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What is an Individual Retirement Account (IRA)? 4 Types and How It Works Explained

In this article

  1. What is an IRA?
  2. How does an IRA work?
  3. When can you withdraw from an IRA?
  4. Types of IRAs
  5. Comparing IRA types
  6. How to start a ROTH IRA or traditional IRA
  7. What IRA is best for me?
  8. An IRA can help you get closer to your retirement goals
  9. FAQs

An IRA plan can help you save for retirement while enjoying some tax benefits. You could open a traditional or Roth IRA to save, on top of contributing to a 401(k), depending on your goals.

A $100 bill sits in a white piggy bank on a table.

Rebecca Lake • December 20, 2023

Opening an IRA might be on your to-do list if you’re ready to start thinking about your retirement goals.

Short for Individual Retirement Account, an IRA is designed to help you invest for the future. But what is an IRA plan exactly, and how does it work?

We’ll break down the basics of an IRA and how it can help you save for the long term.

What is an IRA?

An IRA is a special type of investment and savings account that helps you save money for your retirement years while enjoying some tax benefits.

When you invest in an IRA, you’re typically putting your money into the stock market. For example, you might invest in stocks, mutual funds, or bonds. This means your money has more of a chance to grow and increase in value over time versus keeping it in a savings account or CD, which are relatively liquid assets.

What is an IRA plan meant to do for you? Simply, it’s meant to help you grow wealth for retirement, either alongside a workplace plan if you have access to one or in place of an employer’s plan if you don’t.

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How does an IRA work?

An IRA plan works by allowing you to contribute money during your working years that you can withdraw later once you retire. Unlike a 401(k), which lets you contribute money automatically from your paychecks, it’s up to you to decide how often—and how much—to put into an IRA.

When can you withdraw from an IRA?

You can put money into an IRA as long as you have earned income, but there are some limits on when you can take it out again.

Technically, the IRS requires you to wait until age 59 1/2 before making IRA withdrawals. Does that mean you can’t tap into that money early if you need to? No, but doing so could trigger a 10% early withdrawal penalty. Not to mention, you may have to pay ordinary income tax on the amount you withdraw. That’s also true if you’re cashing out a 401(k) early.1

The IRS offers some exceptions for early withdrawals. You can avoid the 10% penalty if you’re taking money out early for any of the following:

  • Qualified education expenses
  • First-time homebuyer expenses, up to $10,000
  • Health insurance premiums paid out of pocket while unemployed
  • Eligible unreimbursed medical expenses
  • Rollovers
  • Distributions because you’re called to active military duty

Exceptions are also allowed if the account owner passes away or becomes totally and permanently disabled. Additionally, the IRS can use what’s called a levy to take money out of your IRA to satisfy unpaid tax debts. You wouldn’t have to pay the early withdrawal penalty in that case either.2

Types of IRAs

There’s more than one type of IRA plan you can choose from when saving for retirement. There are three main categories of IRA: traditional, Roth, and IRAs for business owners or self-employed individuals. If you’re wondering how to start planning for retirement, here’s an overview of how they work.

Roth IRA

A Roth IRA offers the benefit of tax-free distributions in retirement. You can contribute to a Roth IRA if you have earned income and you’re within the income guidelines set by the IRS. The IRS caps annual contributions to Roth IRAs. The maximum contribution allowed for 2024 is $7,000, or $8,000 if you’re 50 or older.3

For 2024, you’re eligible to make a full contribution to a Roth IRA if:

  • You file your taxes as single, head of household, or married filing separately, and your modified adjusted gross income is less than $161,000
  • You’re married, file a joint return, and your combined MAGI is less than $24o,000
  • You’re married, file separately but still live together, and your MAGI is less than $10,000³

In order to use the higher income limit if you’re married and file separately, you can’t live together during the year. If eligible, you can make contributions to a Roth IRA as long as you have earned income, regardless of age. And you can leave money in your account indefinitely, which is a plus if you’re trying to build generational wealth.

Traditional IRA

Traditional IRAs allow for tax-deductible contributions, then tax withdrawals as ordinary income in retirement. The IRS doesn’t place any income limits on who can contribute to a traditional IRA. You just need to have earned income for the year.4

Contribution limits to traditional IRAs are the same as Roth IRAs. Whether you can deduct your full contribution depends on your filing status and whether a retirement plan at work covers you.

If you’re covered by a plan at work, you can deduct your full contribution if:

  • You file single or head of household, and your MAGI is $87,000 or less
  • You’re married filing jointly, or a qualifying widower, and your MAGI is $143,000 or less3

You can take a partial deduction if you’re married filing separately and your MAGI is $10,000 or less. If you’re not covered by a plan at work, then deductible contributions are only limited if you’re married and a workplace plan covers your spouse.

You can deduct the full amount of your contribution if:

  • You’re married and filing jointly, your spouse is covered by a plan at work and your MAGI is $240,000 or less
  • You’re married filing separately, your spouse is covered by a plan at work and your MAGI is $10,000 or less3

Traditional IRAs require you to take minimum distributions from the plan starting at age 73. If you miss the end-of-year deadline for taking RMDs, the IRS can charge you a hefty penalty. The penalty is 50% of the amount you were required to withdraw. Again, Roth IRAs don’t have that rule.9

SEP IRAs

A SEP IRA, or Simplified Employee Pension, is a special type of IRA for people who own businesses or are self-employed. In terms of tax treatment, they work like traditional IRAs: contributions may be tax-deductible, and withdrawals are taxed as ordinary income.

Here are some of the main points to know about SEP IRAs.

  • SEP IRAs are available to any size business, including freelancers and independent contractors.
  • Contributions are 100% funded by employers, not employees.
  • Employees must meet IRS eligibility requirements for an employer to contribute on their behalf.
  • For 2024, the maximum SEP IRA contribution is $69,000.6
Just like traditional IRAs, SEP IRAs are subject to RMD rules.

SIMPLE IRAs

A SIMPLE IRA, or Savings Incentive Match Plan for Employees, is another retirement savings account for businesses. These plans have some key differences that set them apart from SEP IRAs.

  • SIMPLE IRAs are typically used by smaller businesses with 100 or fewer employees.
  • Both employers and employees can make SIMPLE IRA contributions.
  • For 2024, the maximum annual contribution limit for SIMPLE IRAs is $16,000.
  • Savers 50 and older can also make $3,500 in catch-up contributions to a SIMPLE IRA in 2024.6

Since they follow traditional IRA rules, SIMPLE IRAs are also subject to RMD requirements.

Comparing IRA types

With so many different IRA plans, it can get a little confusing. So it helps to know how they measure up. Here’s an overview of how the different types of IRAs compare.

Traditional IRA3Roth IRA3SEP IRA6SIMPLE IRA6
Designed forPeople with earned incomePeople with earned income that’s within the allowed MAGI guidelinesBusinesses of any size, including freelancers and independent contractorsSmaller businesses with 100 or fewer employees
Tax treatment of contributionsContributions are tax-deductible for eligible saversContributions are not tax-deductibleContributions are tax-deductible for eligible saversContributions are tax-deductible for eligible savers
Tax treatment of withdrawalsQualified withdrawals are taxed as ordinary incomeQualified withdrawals are tax-freeQualified withdrawals are taxed as ordinary incomeQualified withdrawals are taxed as ordinary income
Annual contribution limits (2023)$7,000, plus $1,000 in catch-up contributions for savers 50 or older$7,000, plus $1,000 in catch-up contributions for savers 50 or older$68,000$16,000, plus $3,500 in catch-up contributions for savers 50 or older
Required minimum distributions (RMDs)YesNoYesYes

Again, the main differences between SEP and SIMPLE IRAs vs. traditional or Roth IRA plans lie in who uses them and how much you can contribute.

How to start a ROTH IRA or traditional IRA

The process is fairly simple if you’re interested in using a Roth or traditional IRA to save for retirement. Here’s how it typically works.

  • Research online brokerages that offer traditional and Roth IRA plans.
  • Choose a brokerage to open your account, taking into account the fees you’ll pay and the range of investments offered.
  • Complete the online account opening form and submit any requested documentation, including proof of ID.
  • Select your investments and make your initial deposit.

Once your IRA plan is open, you can make new contributions manually or set up a recurring deposit each month. You’ll have until the April tax filing deadline to make IRA contributions for the previous year.

What IRA is best for me?

Is a Roth or traditional IRA better? It depends on your financial situation and long-term goals.

As a general rule of thumb, you might choose a traditional IRA if you’d like an upfront tax deduction for contributions, and you expect to be in a lower tax bracket when you retire. If you’re already paying less in taxes once you retire, then having to pay income tax on IRA distributions might not make much of a difference to your bottom line.

On the other hand, you might choose a Roth IRA if you’d like to withdraw money tax-free down the line. A Roth IRA also allows you to escape the required minimum distribution rules. If you have other savings you plan to tap into for retirement, you can leave your Roth IRA balance to continue growing tax-free until you need it.

An IRA can help you get closer to your retirement goals

Investing in a traditional IRA or a Roth account may seem a little overwhelming initially, but it helps to know how they work and what they can do for you. And getting some tax benefits is a great incentive to prioritize funding a retirement account.

Once you know your way around an IRA, start putting together a plan to save for retirement.

FAQs

What is an IRA?

An IRA is an Individual Retirement Account that allows you to save money on a tax-advantaged basis. An IRA is funded by your contributions only, unlike a 401(k) plan which can allow for employer-matching contributions. Contributions may be tax-deductible with a traditional IRA, while Roth IRAs allow for tax-free distributions.

What is the purpose of an IRA plan?

IRA plans are designed to help you save money for retirement while accruing some tax breaks. You can use an IRA to save in place of a workplace plan if you don’t have access to a 401(k) or supplement your workplace retirement savings.

What is the downside of an IRA?

The main downside of an IRA is that contribution limits tend to be much lower than 401(k) plans, so you can’t save as much money in them each year. Aside from that, it’s also important to remember that an IRA isn’t a piggy bank you can tap into at any time. Withdrawing money before age 59 1/2 can result in tax penalties.

What is the difference between a 401k and an IRA?

A 401(k) is an employer-sponsored retirement plan that can be funded by employer and employee contributions. IRA plans, on the other hand, are only funded by you with no employer match offered. The IRS allows for higher annual contributions to 401(k) plans compared to IRAs, though the tax benefits of each type of account are similar. Find out more about the differences between 401(k)s and IRAs.

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1 Information from the IRS's "What if I withdraw money from my IRA?" as of July 17, 2023: https://www.irs.gov/newsroom/what-if-i-withdraw-money-from-my-ira

2 Information from the IRS's "Retirement Topics - Exceptions to Tax on Early Distributions" as of July 17, 2023: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

3 Information from the IRS's "Roth IRAs" as of July 17, 2023: https://www.irs.gov/retirement-plans/roth-iras

4 Information from the IRS's" Retirement Topic - IRA Contribution Limits" as of July 17, 2023: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

5 Information from the IRS's "Amount of Roth IRA Contributions You Can Make for 2023" as of July 17, 2023: https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2023

6 Information from the IRS's "Traditional IRAs" as of July 17, 2023: https://www.irs.gov/retirement-plans/traditional-iras

7 Information from the IRS's "2023 IRA Deduction Limits - Effect of Modified AGI on Deduction if You Are Covered by a Retirement Plan at Work" as of July 17, 2023: https://www.irs.gov/retirement-plans/2023-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work

8 Information from the IRS's "2023 IRA Deduction Limits - Effect of Modified AGI on Deduction if You Are NOT Covered by a Retirement Plan at Work" as of July 17, 2023: https://www.irs.gov/retirement-plans/2023-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-not-covered-by-a-retirement-plan-at-work

9 Information from the IRS's "Retirement Plan and IRA Required Minimum Distribution FAQs" as of July 17, 2023: https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs

10 Information from the IRS's "Simplified Employee Pension (SEP)" as of July 17, 2023: https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep

11 Information from the IRS's "SEP Plan FAQs" as of July 17, 2023: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps

12 Information from the IRS's "SIMPLE IRA Plan" as of July 17, 2023: https://www.irs.gov/retirement-plans/plan-sponsor/simple-ira-plan

13 Information from the IRS's "Retirement Topics - SIMPLE IRA Contribution Limits" as of July 17, 2023: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-simple-ira-contribution-limits

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