An Individual Retirement Account (or as the IRS booklet calls it, an Individual Retirement Arrangement), is a personal savings plan that allows an individual to set aside money for retirement in a way that has tax advantages. Investments made within an IRA plan grow in a tax free environment. IRAs are the result of the Federal government implementing a series of laws designed to encourage people to save for retirement themselves instead of counting on company pension plans or other company retirement vehicles.
An IRA is a type of plan called a Defined Contribution Plan. Before 1974, when the first laws were passed allowing IRAs, most if not all the retirement plans were Defined Benefit Plans. A Defined Benefit Plan, usually called a Pension, detailed the benefits you would receive based on how many years you stayed in the plan. If you stayed on the job for X number of years, your employer guaranteed a pension that gave you a list of benefits AFTER you retired, with the employer taking the responsibility for the cost of those benefits. I won’t go into the issues created in many companies by not funding these liabilities until they were current liabilities….
Foreseeing the potential issues with Defined Benefit Plans, the Feds passed the IRA laws (ERISA in 1974 was the first) to allow companies to transition from Defined Benefit Plans to Defined Contribution Plans, where the onus for building one’s retirement account could be removed from the employer and placed on the employee. 401(k) accounts are the main example of employer sponsored Defined Contribution Accounts where the employee is responsible for the Contribution, directing a portion of earnings from each paycheck to be placed into the 401(k) account. The money so diverted is not subject to income taxes and the earnings on the money in the account are also not subject to taxes.
This transition from Defined Benefit Plans to Defined Contribution Plans really took hold in the 1980’s. Very few companies remain that offer traditional pensions to their employees, but most larger companies offer 401(k) accounts to their employees.
Whereas 401(k) accounts are used in place of employer sponsored pension plans, IRAs establish a way for individuals, outside of employer sponsored plans, to contribute money each year toward their retirement. Many different IRA types exist, each with their own requirements and characteristics. Recently, new types of IRAs or IRA-like accounts have been introduced which encourage individuals to save for other life events apart from retirement, such as Education and Health Care. All these types of accounts have as their main benefit the fact that the money in the accounts can grow tax free while still in the account.
To summarize, an Individual Retirement Account allows you to contribute money from your earnings each year toward saving for your retirement. In most cases, the amount of the contribution is deductible from your taxes and any appreciation you realize within the account is not taxed while it is still in the account. These benefits alone are enough to encourage millions of Americans each year to contribute to IRAs to save for their retirements.
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I appreciate the way you explain the IRA. Different types of IRA is always confusing to understand and choosing them.