Individual Retirement Account (IRA): What It Is, 4 Types

What Is an IRA? Definition and Purpose

An individual retirement account (IRA)—known as an individual retirement arrangement by the IRS—is a long-term, tax-advantaged savings account that individuals with earned income can use to save for the future.

The IRA is designed primarily for self-employed people who do not have access to workplace retirement accounts such as the 401(k), which is available only through employers. However, you can also have an IRA even if you already have a retirement plan at work.

You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.

How Does an IRA Work?

Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the total that you can contribute to your retirement accounts in a single year.

The best IRA accounts will offer the ability to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds.

There are also self-directed IRAs (SDIRAs) that permit investors to make all the investing decisions. SDIRAs offer access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.

There are several kinds of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These types include:

• Traditional IRAs
• Roth IRAs
• Simplified Employee Pension (SEP) IRAs
• Savings Incentive Match Plan for Employees (SIMPLE) IRAs

Individual taxpayers can establish traditional and Roth IRAs. Small business owners and self-employed individuals can set up SEP and SIMPLE IRAs.

An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerages, federally insured credit unions, and savings and loan associations.

Because IRAs are meant to be used to invest and maximize the growth of funds for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. That's in addition to taxes you'd pay on the withdrawn amount.

However, there are some notable exceptions to the penalty rule—withdrawals for educational expenses and first-time home purchases, among others.

A Roth account is funded with post-tax money, so no further taxes are due when the money is withdrawn.

IRA Types: Traditional, Roth, SEP, and SIMPLE Compared

The following is a breakdown of the various types of IRAs and the rules regarding each one.

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. So, if you put $4,000 into an IRA, your taxable income for the year decreases by that amount.

In a traditional IRA, your money grows tax-deferred. When you withdraw it after retiring, it is taxed at your ordinary income tax rate for that year.

Contribution Limits

Contribution limits can change from year to year, so it’s smart to check the IRS website for the latest numbers before you make your contributions.

If you don’t have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a 401(k) or 403(b), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted.

If You Have a Retirement Plan at Work

Your ability to deduct traditional IRA contributions depends on your income if you or your spouse are covered by a workplace plan like a 401(k) or 403(b). The higher your income, the more likely your deduction will be partially reduced or phased out. Because the IRS updates these income limits regularly, check IRS.gov each year to see how much you can deduct.

The income limits are lower if you file as single or head of household and higher if you are married filing jointly, which means joint filers can typically earn more before their deduction begins to phase out.

If You Don't Have a Plan at Work but Your Spouse Does

If you contribute to a traditional IRA and aren’t covered by a workplace plan but your spouse is, your ability to deduct contributions generally depends on your household’s income and applies when you file jointly. The deduction begins to phase out once your income reaches a certain level. The IRS adjusts this amount each year; find the latest information on IRS.gov.

Roth IRA

Roth IRA contributions are not tax-deductible in the year in which you make them. But the distributions are tax-free. That means you contribute to a Roth IRA using after-tax dollars and pay no taxes, even on your investment gains.

Also, Roth IRAs do not have RMDs. If you don’t need the money, you don’t have to take it out of your account (where it continues growing tax-free). You can contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits in any given tax year are usually the same as they are for traditional IRAs. However, there is a catch: There are income limitations on contributions to a Roth IRA.

The phase-out range is the income window where your allowed Roth IRA contribution gradually decreases until you can no longer contribute. Since these ranges are updated each year, visit IRS.gov to confirm how much you can contribute based on your current income.

SEP IRA

Self-employed individuals such as independent contractors, freelancers, and small-business owners can set up SEP IRAs.

A SEP IRA follows the same tax and withdrawal rules as a traditional IRA, but contributions work differently. They are capped at a percentage of your compensation, up to an annual limit set by the IRS. Because these limits are adjusted periodically, check IRS.gov for the current maximum before contributing.

Business owners who set up SEP IRAs for their employees can deduct the contributions they make on behalf of employees. However, the employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.

Unlike SEP IRAs, SIMPLE IRAs allow employees to contribute to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially lowering the business or employee's tax bracket.

Employee contributions are subject to annual limits set by the IRS, with an additional catch-up contribution allowed for those age 50 or older. Because these limits are adjusted periodically, check IRS.gov for the most current contribution amounts.

Required Minimum Distributions (RMDs): When and How They Apply

Required minimum distributions (RMDs) are withdrawals that owners of traditional IRA and 401(k) accounts must take every year after they reach a certain age. The age has been revised upwards a couple of times. As of Jan. 1, 2023, an account holder must begin taking money out in the year they turn age 73. That age rises to 75 in 2033.

The amount a person must withdraw is based on the account size and the person's life expectancy. The IRS has a worksheet to calculate the amount.

Failure to take the minimum triggers a severe tax penalty, which is 25% of the balance of the account. That's half the previous penalty but still expensive enough to keep us on our toes.

However, this penalty can be reduced to 10% in many cases if the taxpayer takes corrective action early.

Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

Note: To view the full chart, use the slider at the bottom to see the column at the far right.