What an IRA Is for and How It Works
When you stop working, you still need to pay for food, housing, and other expenses, but where does the money come from if you’re no longer earning income? There are several potential sources of retirement income, including Social Security benefits and pension income from a former employer. You can also save money on your own using personal accounts or an employer-sponsored plan like a 401(k) or 403(b).
What Is an IRA?
An individual retirement account (IRA) is an account with tax features that help individuals save for retirement expenses. Also known as an individual retirement arrangement, these accounts can hold your retirement savings from several sources, including contributions that the individual makes to the account and savings that originally came from an employer-sponsored retirement plan.
Your retirement savings can supplement income sources like Social Security and pensions. Plus, retirement accounts can provide a substantial pool of funds when you need to take a withdrawal in a lump sum.
Types of IRAs
An IRA is a type of account that may look and feel like any other account (such as your taxable brokerage account or a bank account). But certain tax features make retirement accounts different from other kinds of accounts. Lawmakers designed these accounts to promote retirement savings, so there are potential benefits to using the accounts. There are also restrictions that discourage early withdrawals.
There are two types of IRAs, and taxes are handled differently on each one. Before you choose which type of IRA to use or make a contribution, discuss your goals and your situation with a tax professional.
Traditional IRAs provide tax-deferred growth; income in the account is not taxed every year as it would be in a standard bank account. Instead, you can reinvest any earnings and take advantage of compounding in the account.
You might also get tax benefits in the form of a deduction for money that you contribute to a traditional IRA, allowing you to add “pre-tax” money to your account. However, you might not be eligible for the deduction depending on your household income and workplace benefits, so you may need to make after-tax contributions. When you take funds out of the account (to spend in retirement, for example), any funds that have never been taxed—any pre-tax contributions and earnings—are treated as income in the year you take the distribution.
Roth IRAs offer the potential for tax-free growth. Instead of taking a deduction for contributions, you contribute after-tax dollars to Roth accounts. When you take distributions in retirement, you might receive all of the money tax-free (assuming you satisfy all IRS requirements). In other words, you get your original contributions and any earnings tax-free.
Roth IRAs have unique restrictions that don't apply to traditional IRAs, including a five-year waiting period and income limits that may prevent you from contributing. That said, you can generally take your contributions back out of a Roth at any time without taxes or penalty. That makes Roth IRAs relatively flexible for unexpected needs, but you may have tax consequences if you remove earnings from the account.
Rollover IRAs are traditional IRAs that receive funds from another retirement account. For example, you might roll pre-tax 401(k) assets into a rollover IRA. In the past, those assets might have been kept separate, but combining assets is currently the norm.
Still, there may be good reasons to keep separate IRAs for different money sources. When you're concerned about creditor protection, retirement plan rules, and other issues, a "conduit IRA" may be appropriate.
You can combine retirement savings from several sources into a single IRA—including a traditional IRA—for simplicity. In some cases, it's best to keep your contributions separate from funds from an employer plan, so check with a professional before if you have any questions.
Some employer-provided plans like SEPs and SIMPLEs are also technically IRAs. They have features that are similar to traditional IRAs, but the rules are different because they are designed for small businesses or self-employed individuals. For example, contribution limits are higher. With SIMPLE IRAs, the early-withdrawal penalty is more restrictive than with traditional or Roth IRAs.
Retirement accounts can help you save a significant amount of money for retirement. However, IRS rules limit tax benefits so that the U.S. Treasury continues to receive sufficient funding. This page provides an introductory overview, but it is not a complete list of rules. There are always complications and easy-to-miss details, and several sophisticated strategies may allow you to legally work around some of the rules. Speak with a financial professional to get individualized advice on how to manage your savings.
The IRS limits the maximum amount you can contribute to a standard IRA every year. Rollovers and transfers from other retirement accounts generally do not count against those limits, but there are complicated pitfalls with transfers—so talk with an expert before you move money.
Depending on how you transfer money between retirement accounts (as a direct rollover, trustee-to-trustee transfer, or 60-day rollover, for example), you may need to follow specific IRS rules. Choose your transfer method carefully.
IRAs are designed to fund retirement. While you’re allowed to retire at any age, the IRS uses age 59 ½ as the age at which you can avoid certain tax penalties on withdrawals from IRAs. You can take distributions before then, but you may have to pay tax penalties (in addition to income tax) for early withdrawals unless you meet certain criteria or use advanced strategies. That penalty is typically 10% of the amount you withdraw, but it can be 25% for SIMPLE IRA plans.
When you have pre-tax money in traditional IRAs, you eventually need to start taking money out and generating tax revenue. After age 70 ½, the IRS mandates Required Minimum Distributions (RMDs) from traditional IRAs, which are designed to draw down your account over your life expectancy. Roth IRAs do not have RMDs for the original contributor but some inherited Roth IRAs must use RMDs.
Pre-tax or Post-tax?
The ability to deduct contributions to a traditional IRA has been an appealing feature for decades. Savers can potentially reduce their taxable income, which makes it easier to afford contributions. However, they’re choosing to pay taxes later instead of today. Whether or not that makes sense is an unknown—we can't know what tax rates will look like in the future, or how the tax system might change in surprising ways.
Roth IRAs allow savers to prepay taxes, but again, there are several unknowns (such as where tax rates will go, how the rules might change, and more). If you have more in traditional accounts than you’d prefer, you can convert assets from a traditional IRA to Roth, but there may be unexpected tax consequences for doing so.
Your decision to pay taxes now or later can have a significant impact on your retirement budget. Pre-tax withdrawals can also affect whether or not your Social Security income is taxable and how much you pay in Medicare premiums.
Investments in IRAs
An IRA is just a type of account with tax features. Those features do not have a significant impact on your choices for investments—think of an IRA as a “wrapper” around any other account you’re familiar with.
While there are some exceptions, you can use almost any type of mainstream investment vehicle inside of an IRA, including cash in savings accounts, certificates of deposit (CDs), riskier investments like mutual funds or ETFs, and more. The right investment for you will depend on several factors, including your goals and your ability to take risks with your savings.
Where to Open an IRA
You can open an IRA at banks, credit unions, investment firms, and other financial institutions. Ask any provider about the types of investments available, annual custodial fees and additional charges, and other features to determine where you should open your IRA.
Tax laws are complicated, and things may have changed since this article was originally written. It’s essential to verify the facts for yourself before making decisions about your money, as this page may contain errors and omissions. Check with the IRS or visit with a professional tax advisor.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.