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An individual retirement account (IRA) allows you to set aside money for the future while also securing some key tax benefits. It's mainly designed for self-employed folks, but anyone can use an IRA to supercharge their nest egg—even if they have a 401(k) or other employer-sponsored retirement plan. Think of it as another way to build your long-term savings.
Here are important IRA facts to consider, which we'll unpack in more detail.
- You can open an IRA on your own
- There are different kinds of IRAs
- IRAs have contribution limits
- Some IRAs have income limits
- There may be withdrawal rules
- Required minimum distributions (RMDs) may apply
- You can invest IRA funds and grow your nest egg
Let's talk about the different types of IRAs, how they work and how to open an IRA for yourself. We'll also touch on some IRA alternatives if you decide it isn't the right investment vehicle for you.
What Is an IRA?
An IRA is a type of tax-advantaged investment account that helps you save for retirement. Depending on the type of IRA you have, you'll either contribute with pretax earnings, saving you on taxes in the year you contribute, or withdraw money tax-free in retirement.
IRAs have similar benefits to a 401(k), but you don't need employer sponsorship to invest in one. They're a simple, accessible way to start building financial security in retirement now.
Learn more >> What Is a Tax-Deferred Retirement Account?
How Does an IRA Work?
When it comes to saving for retirement, an IRA can be one of your greatest tools. They offer tax benefits and can help accelerate your savings. Here are some of the most compelling reasons to open an IRA.
1. Tax Savings
There are different types of IRAs, and each one offers unique tax advantages. Some allow you to take a tax deduction on contributions. Others offer tax-deferred growth, which means that you won't pay taxes until you make withdrawals in retirement. These tax perks can unlock significant savings over time.
2. Opportunity to Earn Compound Interest
Investing in an IRA allows you to leverage the power of compound interest. That's because you'll earn interest on your principal investment and your earnings. Compounding can help your retirement savings grow at a faster clip. The longer you're invested, the more time your money has to grow. That's why saving early and often is one of the golden rules of saving for retirement. (If you're feeling behind here, remember that starting late is better than never starting at all.)
3. Money Waiting for You in Retirement
When you retire, you'll begin drawing on your savings and other sources of income. A Roth IRA can provide tax-free withdrawals (assuming you're 59½ or older and have held the account for at least five years). With a traditional IRA, withdrawals are considered taxable income. Having a diverse mix of retirement income can help minimize your tax burden when you're no longer working.
Types of IRAs
Traditional IRAs
With a traditional IRA, contributions may be tax deductible, which can help reduce your taxable income during your working years. That, in turn, can indirectly lower your tax liability. Deducting the contributions you make to a traditional IRA is a key tax benefit. But if you're covered by a retirement plan at work, you may be limited in how much you can deduct on your tax return.
The chart below shows how your modified adjusted gross income affects the amount you can deduct for traditional IRA contributions. (If you are married but file separately and did not live with your spouse at any time during the year, refer to the IRA deduction limits for single filers.)
| 2024 IRA Deduction Limits if You're Covered by a Retirement Plan at Work | ||
|---|---|---|
| Filing Status | 2024 Modified Adjusted Gross Income | Amount You Can Contribute |
| Single or head of household | $77,000 or less | Full deduction up to the maximum contribution |
| More than $77,000 but less than $87,000 | Partial deduction | |
| $87,000 or more | Zero | |
| Married filing jointly or qualifying widow(er) | $123,000 or less | Full deduction up to the maximum |
| More than $123,000 but less than $143,000 | Partial deduction | |
| More than $143,000 | Zero | |
| Married filing separately | Less than $10,000 | Partial deduction |
| $10,000 or more | Zero |
Source: IRS
Money in a traditional IRA grows tax-deferred. That means you won't owe taxes until you take money out in retirement. While you can have both a traditional and Roth IRA, the annual contribution limit is combined. In 2024, you can contribute up to $7,000 across all traditional and Roth IRAs. Folks who are 50 and older can kick in an additional $1,000 in catch-up contributions.
Withdrawing funds before age 59½ usually triggers a 10% early withdrawal penalty. And you must start taking required minimum distributions (RMDs) starting at age 73.
Learn more >> What's the Difference Between a Roth IRA and a Traditional IRA?
Roth IRAs
You won't get a tax break on the money you put into a Roth IRA, but you can withdraw your contributions tax-free at any time. However, pulling out investment earnings could trigger taxes and a penalty if you're younger than 59½ and have had the account for less than five years. RMDs do not apply to Roth IRAs (unless it's an inherited account).
It's also worth noting that there are income requirements to contribute to a Roth IRA. Earning too much could reduce the amount you can contribute.
| 2024 Roth IRA Contribution Limits | ||
|---|---|---|
| Filing Status | 2024 Modified Adjusted Gross Income | Amount You Can Contribute |
| Single, head of household or married filing separately (and you did not live with your spouse at any time during the year) | Less than $146,000 | Up to the maximum |
| $146,000 to $160,999 | A reduced amount | |
| $161,000 or more | Zero | |
| Married filing jointly or qualifying surviving spouse | Less than $230,000 | Up to the maximum |
| $230,000 to $239,999 | A reduced amount | |
| $240,000 or more | Zero | |
| Married filing separately | Less than $10,000 | A reduced amount |
| $10,000 or more | Zero |
Source: IRS
Simplified Employee Pension (SEP) IRAs
SEP IRAs are geared toward business owners and have higher contribution limits than traditional IRAs. But if you open one for yourself, you'll have to do the same for each of your employees.
SEP IRAs can only be funded with employer contributions—and the contribution rate has to be the same for everyone. In 2024, you can contribute up to $69,000 or 25% of compensation, whichever is less.
Savings Incentive Match Plans for Employees (SIMPLE) IRAs
SIMPLE IRAs are designed for business owners who have up to 100 employees. As the employer, you're required to contribute to each eligible employee's SIMPLE IRA in one of the following ways:
- A dollar-for-dollar match up to 3% of annual compensation or
- A flat 2% contribution for each eligible employee (up to $345,000 of compensation)
Employer contributions are tax deductible, but you'll have to contribute the same amount across the board—if you match 100% of your own contributions, you'll have to do the same for your employees. Your workers can also make contributions of their own. In 2024, they can put in up to $16,000 (employees who are 50 or older can contribute an extra $3,500).
Rollover IRAs
These IRAs are used to transfer money out of an employer-sponsored retirement plan—like an old 401(k) you have with a past employer. You can also use a rollover IRA to consolidate stray retirement accounts, including IRAs, into a single account. That could make things easier to manage and give you greater control over how your funds are invested. But be aware that rolling retirement funds into a new IRA might be considered a taxable event:
- Moving money from a 401(k) or traditional IRA into a new traditional IRA: Since 401(k)s and traditional IRAs are both tax-deferred accounts, you shouldn't owe taxes on the rollover.
- Moving money from a 401(k) or traditional IRA into a new Roth IRA: Roth IRAs are funded with after-tax dollars. That means you'll owe taxes on the amount you roll over.
Spousal IRAs
A spousal IRA allows non-working or low-income spouses to contribute to their own tax-advantaged retirement account based on their spouse's taxable income. To qualify:
- You must be legally married and file your taxes jointly
- One of you must earn taxable compensation
Once it's up and running, either spouse can contribute to the IRA. You can also structure the account as a traditional IRA or Roth IRA.
Roth IRA vs. Traditional IRA
The most common types of IRAs are Roth and traditional IRAs. They both can help grow your retirement nest egg, but the rules for income, taxes and contributions vary widely.
| IRA Comparison | ||
|---|---|---|
| Roth IRA | Traditional IRA | |
| Maximum annual contribution (2020) | $6,000 ($7,000 if age 50 or over by end of year) | $6,000 ($7,000 if age 50 or over by end of year) |
| Maximum income allowance | $139,000 for individuals filing as single; $206,000 for married couples filing jointly | None |
| Contributions tax-deductible? | No | Maybe, depending on your income and whether you have a retirement plan at work |
| Withdrawal of contributions subject to income tax? | No | Yes |
| Withdrawal of fund earnings subject to income tax? | Maybe, if withdrawals are made before age 59 1/2 | Yes |
| Early withdrawal penalty? | Some withdrawals of fund earnings made before age 59 1/2 are subject to 10% penalty | 10% penalty on some withdrawals made before age 59 1/2 |
| Age restriction on contributions | None | 70 1/2 |
| Age when distributions become mandatory | None | 70 1/2 |
How to Open an IRA
Opening a new IRA is a relatively easy process. Here's a step-by-step guide:
- Choose the type of IRA that works best for you. If you want tax-free withdrawals in retirement, a Roth IRA could be a good option. Meanwhile, a traditional IRA can offer tax benefits during your saving years. The right option for you will depend on your financial situation and retirement goals.
- Select an IRA provider. IRAs are available at banks, credit unions, mutual fund companies, brokerages (including online brokerages) and robo-advisors. Unlike a 401(k), which is offered as an employee benefit, IRAs are available to anyone.
- Fund your account. You can make a lump-sum initial deposit and continue adding to it each month via automatic transfers. You might also choose to transfer funds from an old 401(k) or IRA.
- Manage your investments. Your investment strategy will depend on your age, financial goals and risk tolerance. Having said that, you can use an IRA to invest in exchange-traded funds (ETFs), mutual funds, index funds, bonds and other assets.
Learn more >> How to Save Money for Retirement
Alternatives to IRAs
IRAs have many advantages, but they're not the only way to build your nest egg. Other options to consider include:
- An employer-sponsored retirement account: That might be a 401(k), 403(b) or other workplace plan. These can provide a simple way to save for retirement—and your employer might match some or all of your contributions. If it does, it's wise to contribute at least the matched amount, even if you also want other retirement savings options.
- A regular brokerage account: Brokerage accounts don't offer tax benefits, but you can use them to sock away extra money for the future. There are no withdrawal restrictions or required distributions, but you can expect to be taxed on gains during the year they're realized.
- A health savings account (HSA): With an HSA, you can set aside pretax dollars to cover qualified medical expenses. Once you turn 65, you can use HSA funds for any reason. Non-qualified distributions count as taxable income.
Frequently Asked Questions
Like any investment, it's possible to lose money with an IRA. Your asset allocation—or the investments housed in your IRA—is an important factor. If the bulk of your portfolio is made up of high-risk assets, you might consider rebalancing it—especially if you're getting close to retirement. That said, you can expect your IRA balance to move up and down with regular market activity. Your account can also be affected by interest rate changes, inflation and global and domestic politics.
Required minimum distributions (RMDs) are the minimum amount you have to withdraw from a retirement account each year after you reach age 73 or 75, depending on what year you were born.
If you have money in a tax-deferred retirement account, you'll owe taxes when you make withdrawals. RMDs ensure that you take distributions—and pay your fair share to Uncle Sam. Failing to take your RMDs could result in hefty IRS penalties.
The main difference is 401(k)s are offered by employers. You open and fund IRAs yourself, making them ideal for self-employed people. It's also possible to have a 401(k) and an IRA at the same time. Each can provide unique tax advantages.
A SEP is technically a type of IRA. Whether it's right for you will depend on your business revenue and how many employees you have. As an employer, you'll be required to contribute to employees' accounts. That said, a SEP IRA's high contribution limits make it an attractive option. It might also help you attract and retain talent.
The Bottom Line
Saving for the future is an important part of financial wellness—whether you choose to open an IRA or not. IRAs offer a tax-friendly way to save for retirement. They can be especially appealing to self-employed folks who are looking to grow their nest egg. You can also use an IRA with a 401(k) or other employer-sponsored account to grow your savings over time. Each one has its own benefits and drawbacks.
Once you're retired, guaranteed income sources like Social Security benefits and annuities can provide extra financial peace of mind. The same can be said about cash value life insurance. The goal is to patch together different sources of income to fund your retirement in the most tax-efficient way possible.