Retirement accounts: What an IRA is -- and why you need one

If you're one of the millions of Americans who quit their job or made a career change during "The Great Resignation," you may have a 401(k) account sitting dormant. As this is an employer-sponsored retirement account, you can no longer contribute to it, limiting your nest egg's growth potential. One option for making the most of your old 401(k) is to roll it into an Individual Retirement Account, which is quite similar to a 401(k) -- just not tethered to, or sponsored by, an employer.

If you've decided to work for yourself or return to school, you may no longer be able to put more money into that "defined contribution" plan anymore. By transferring the funds in your 401(k) with a previous employer to an IRA, you'll be able to continue contributing to a retirement account -- even though you've left that job.

Here is everything you need to know about IRAs and how to decide which one is right for you.

What is a traditional IRA?

A traditional IRA is a tax-advantaged savings account that you can use to save for retirement. You make pretax contributions during your working years, and your money is taxed as ordinary income when you withdraw it in retirement. Unlike a 401(k), it isn't tethered to your employer and you can set one up through a bank, brokerage or robo-advisor. Traditional IRAs are the most popular type of retirement account, with 23% of Americans owning one. 

While a benefit to traditional IRAs is that there are no income limits for opening or contributing to one, there are contribution limits on how many tax-free dollars you can put in every year. In 2021, the contribution limit is $6,000, or up to $7,000 if you're age 50 or older (you are allowed up to $1,000 in catch-up contributions).

There is, however, an early withdrawal penalty for traditional IRAs. Before the age of 59 and 6 months, in addition to any income taxes you'll owe when you take your money out, the IRS will also slap you with a 10% penalty if it's not for a qualified distribution. 

What is a Roth IRA?

This IRA variant functions similarly to a traditional IRA -- except your money is taxed on the way into the account, paving the way for you to withdraw it 100% tax-free once you're retired. 

This arrangement makes it ideal for younger workers, who are earlier in their careers, or those in low tax brackets. For instance, if you've just started your first job out of college, it's a great time to open a Roth IRA account. Though only about 10% of Americans have Roth IRAs, they offer greater flexibility because you can withdraw your Roth contributions at any time for any purpose -- though there's a 10% tax penalty for withdrawing interest and earnings before the age of 59 and 6 months.

The differences between a traditional and and Roth IRA

The main difference between a traditional IRA and a Roth is that there are income limits for opening or contributing to a Roth IRA. In 2021, as a single person filing your total income must not exceed $140,000. For married couples filing jointly, the limit this year is $208,000.

Roth IRA contributions also have limits: For 2021, the maximum contribution limit is $6,000, but jumps to $7,000 if you are age 50 or over.

Another benefit in the long run is avoiding required minimum distributions (RMDs). Uncle Sam takes RMDs from most retirement accounts every year once you turn 72 years old -- including traditional IRAs. But a Roth IRA is funded with post-tax dollars, so you're not required to make any withdrawals for tax purposes later on if you don't want to.