What it means
An IRA is a wrapper rather than an investment in itself. Inside it you can hold funds, shares, bonds or cash, and the tax treatment applies to whatever you choose to put in.
The two main types differ over when tax is paid. A traditional IRA gives a deduction against income today if you qualify, then taxes withdrawals in retirement as ordinary income, whereas a Roth IRA offers no deduction now but allows qualified withdrawals to come out entirely free of tax.
The choice between them is really a bet on tax rates. If you expect to be in a lower tax bracket in retirement than you are now, the traditional deduction is worth more, and if you expect the reverse, or simply want certainty, the Roth generally wins.
Contribution limits are set annually and are modest compared with employer schemes, and higher earners face restrictions on both the traditional deduction and direct Roth contributions. Money is also intended to stay put, with withdrawals before age 59 and a half typically attracting income tax plus a 10% penalty apart from a short list of exceptions.
For business owners there are variants worth knowing. SEP and SIMPLE IRAs allow much larger contributions for self employed people and small companies, which makes them a practical alternative to running a full pension scheme.
In practice
Real-world examples.
Example
A freelance graphic designer with variable income opens a SEP IRA because it lets her contribute a percentage of profit in good years and nothing in lean ones, without the fixed obligations of a formal pension scheme.
Example
A 26 year old junior analyst chooses a Roth IRA on the reasoning that his current tax rate is the lowest it will ever be, so paying tax now and taking decades of growth tax free is the better trade.
Example
A couple approaching retirement move part of a traditional IRA into a Roth over several years, converting only enough each year to stay inside their current tax bracket and spreading the tax bill rather than facing it all at once.
Think of it
“IRA is the abbreviation for Individual Retirement Account-personal retirement savings.
Formula
Calculation
Future value of regular contributions = annual contribution x [((1 + return) raised to the number of years, minus 1) / return]
Suppose someone contributes $7,000 a year for 30 years and earns an average annual return of 6% inside the account. First, 1.06 raised to the power of 30 is 5.743491.
Subtracting 1 gives 4.743491, and dividing by 0.06 gives an annuity factor of 79.058187. Multiplying by the $7,000 annual contribution gives a projected balance of $553,407 rounded to the nearest dollar.
Total contributions over the period were 30 x $7,000 = $210,000, so investment growth accounts for $553,407 - $210,000 = $343,407 of the final balance. In a Roth IRA that growth is not taxed on qualified withdrawal, which is the whole point of accepting no deduction on the way in.Case study
Seen in the real world.
The following is an illustrative and entirely fictional scenario. Pemberton Tile Works, an invented eleven person flooring contractor, had no retirement provision at all, and its owner assumed setting one up meant expensive administration. Two experienced fitters had already mentioned that larger competitors offered retirement benefits.
The invented owner set up a SIMPLE IRA, which allowed staff to contribute from their pay with the company matching part of it, and cost a fraction of what a full scheme would have needed to administer. The company committed to a match capped at 3% of each employee's pay.
In this fictional example the total annual cost came to roughly $28,000 against a payroll of just under $1,000,000, and both fitters stayed. The owner's own contributions, made through the same arrangement, also reduced the business's taxable profit, which softened the cost considerably.
Watch out
Common mistakes.
- Thinking an IRA is itself an investment, then leaving the whole balance sitting in cash inside the account for years and wondering why it barely grew.
- Withdrawing early to cover a short term need without allowing for income tax plus the 10% penalty, which can take a third or more of the amount taken.
- Assuming everyone can deduct traditional IRA contributions or contribute directly to a Roth, when income limits restrict both.
Questions
People also ask.
Can you hold both a traditional and a Roth IRA?
Yes, but the annual contribution limit applies across both accounts combined, not to each one separately.
What happens to an IRA at retirement?
Traditional IRAs are subject to required minimum distributions from a set age, forcing taxable withdrawals, while Roth IRAs have no such requirement during the original owner's lifetime.
Is an IRA useful if my employer already offers a workplace plan?
Often yes, as extra tax advantaged capacity and usually with a wider choice of investments, though your traditional IRA deduction may be limited if you are covered at work.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%