What an IRA account is and how it works

An IRA (Individual Retirement Account) is a savings account the government lets you open specifically for retirement. The main benefit is tax relief: money you put in may reduce your taxable income this year, and the money inside grows without being taxed each year. You do not pay taxes on the growth until you withdraw the money in retirement.

The account itself is just a container. You open it at a bank, brokerage, or credit union, then decide what to invest the money in—usually stocks, bonds, or mutual funds. The financial institution holds the account and keeps track of your balance. You control what happens inside it, but the government sets rules about how much you can put in each year and when you can take money out without penalty.

IRAs are different from employer retirement plans like a 401(k). You open an IRA on your own, not through your job. You can have an IRA even if you have a 401(k), though there are limits on how much tax benefit you get from both at the same time.

Key Takeaways

  • An IRA is a retirement savings account where your money grows without being taxed each year, though you pay taxes when you withdraw it later.
  • You can contribute up to a set amount each year (the limit changes annually), and you choose what to invest the money in.
  • Traditional IRAs may reduce your taxable income now, while Roth IRAs let you withdraw money tax-free in retirement but do not reduce your taxes today.
  • You cannot withdraw money before age 59½ without paying a 10 percent penalty, with a few narrow exceptions.
  • You must start taking withdrawals at age 73 (as of 2023) from a Traditional IRA, but Roth IRAs have no withdrawal requirement during your lifetime.

Traditional IRA versus Roth IRA: the main difference

The two most common types of IRA are Traditional and Roth, and they work in opposite directions on taxes. With a Traditional IRA, you put in pre-tax dollars (or deduct the contribution on your tax return), which lowers your taxable income this year. The money grows tax-free, but when you withdraw it in retirement, you pay income tax on the full amount. With a Roth IRA, you put in after-tax dollars (no deduction now), the money grows tax-free, and you withdraw it tax-free in retirement.

Which one makes sense depends on whether you think your tax rate will be higher or lower in retirement. If you expect to be in a lower tax bracket when you retire, a Traditional IRA saves you more money overall. If you expect to be in a higher bracket, or if you want to avoid taxes entirely in retirement, a Roth is usually better. Many people use both.

There are income limits on Roth IRAs—if you earn above a certain amount, you cannot contribute to one directly. Traditional IRAs have no income limit, but if you have a 401(k) at work, the tax deduction phases out as your income rises. The IRS website lists the current income thresholds each year.

Annual contribution limits and how they work

The IRS sets a maximum amount you can put into an IRA each year. For 2024, that limit is $7,000 if you are under 50, and $8,000 if you are 50 or older (the extra $1,000 is called a "catch-up" contribution). These limits change most years, so check the IRS website or your financial institution before you contribute.

The limit applies across all your IRAs combined. If you have both a Traditional and a Roth IRA, your total contributions to both cannot exceed the annual limit. You can split the money however you want between them, but the total is capped. If you contribute more than the limit, the IRS charges you a 6 percent penalty tax each year until you withdraw the excess.

You can contribute to an IRA as long as you have earned income (wages from a job). If you are married and one spouse does not work, the working spouse can open a "spousal IRA" for the non-working spouse and contribute to both accounts, up to the limit per account.

How money grows inside an IRA and when you pay taxes

Once money is in an IRA, you choose what to invest it in. Most people buy mutual funds, index funds, or individual stocks through their IRA. Whatever you buy, the gains (or losses) are not taxed each year the way they would be in a regular investment account. If a stock inside your IRA doubles in value, you do not owe taxes on that gain until you withdraw the money.

This tax-free growth is the main reason IRAs are powerful for long-term saving. Over 20 or 30 years, avoiding taxes on yearly gains adds up significantly. In a regular taxable account, you would owe taxes on dividends and capital gains every year, which reduces how much compounds.

With a Traditional IRA, you pay income tax on withdrawals at your ordinary tax rate—the same rate as your salary. With a Roth IRA, you pay no tax on withdrawals at all, as long as the account has been open for at least five years and you are at least 59½. This is why the Roth is often better if you expect to be in a high tax bracket later.

Withdrawal rules and the 10 percent early withdrawal penalty

The government wants you to save for retirement, not use the account as a short-term savings tool. If you withdraw money from an IRA before age 59½, you owe a 10 percent penalty on top of income tax (for Traditional IRAs). For example, if you withdraw $10,000 at age 45, you pay 10 percent ($1,000) as a penalty plus income tax on the full $10,000.

There are a few exceptions where you can withdraw early without the 10 percent penalty. These include a permanent disability, medical expenses over 7.5 percent of your income, health insurance premiums while unemployed, and a first-time home purchase (up to $10,000 lifetime). Roth IRAs have a special rule: you can always withdraw the money you contributed (not the earnings) without penalty, even before 59½.

Once you turn 59½, you can withdraw as much as you want, whenever you want, with no penalty. You still owe income tax on Traditional IRA withdrawals, but the 10 percent penalty is gone. Many people start withdrawing in their 60s or later, depending on when they retire.

Required minimum distributions and when you must start withdrawing

The government does not let you keep money in a Traditional IRA forever without withdrawing it. Starting at age 73 (as of 2023; this age has been rising gradually), you must withdraw a minimum amount each year, called a required minimum distribution (RMD). The IRS calculates this amount based on your age and account balance. If you do not take the RMD, you owe a 25 percent penalty on the amount you should have withdrawn (reduced to 10 percent if you correct it within two years).

Roth IRAs do not have an RMD requirement during your lifetime. You can leave the money in the account as long as you live and pass it to heirs tax-free. This is one reason Roth IRAs are popular for people who do not need the money in retirement.

If you are still working at age 73 and do not own more than 5 percent of the business, you may be able to delay RMDs from a 401(k), but not from an IRA. Talk to a tax professional if your situation is complex.

Opening an IRA and choosing where to hold it

You can open an IRA at most banks, credit unions, and brokerages. Common places include Fidelity, Vanguard, Charles Schwab, and your own bank. Each institution offers different investment options and fee structures, so it is worth comparing a few before you choose.

When you open an account, you will choose whether it is a Traditional or Roth IRA. You will also choose how to invest the money—some people pick a target-date fund (which automatically adjusts as you get closer to retirement), while others pick individual stocks or bonds. If you are not sure what to invest in, a target-date fund is a simple starting point.

Opening an IRA takes about 15 minutes online. You will need your Social Security number, a valid ID, and a way to fund the account (bank transfer or check). Once it is open, you can start contributing right away. There is no deadline to open an IRA for a given year—you can open one in January or December and contribute for that year, as long as you contribute by the tax filing deadline (usually April 15 of the following year).

Frequently Asked Questions

Can I have more than one IRA?

Yes, you can have multiple IRAs at different institutions. However, your total contributions across all IRAs cannot exceed the annual limit. For example, if you have a Traditional IRA at one bank and a Roth IRA at another, your combined contributions to both cannot exceed $7,000 (or $8,000 if you are 50 or older).

What happens to my IRA if I change jobs?

Your IRA is separate from your job, so changing jobs does not affect it. If you have a 401(k) at your old job, you can roll it into an IRA, which gives you more investment choices and often lower fees. A rollover is a direct transfer from your 401(k) to your IRA and does not count as a withdrawal or trigger taxes.

Can I withdraw money from my Roth IRA without penalty?

You can withdraw the money you contributed (not the earnings) at any time without penalty or taxes. Withdrawing the earnings before age 59½ triggers the 10 percent penalty and taxes, unless you may have access to for an exception like disability or a first-time home purchase.

What if I contribute too much to my IRA?

If you over-contribute, you owe a 6 percent penalty tax each year until you withdraw the excess. You should withdraw the excess and any earnings on it as soon as you notice the mistake. Your financial institution can help you file the paperwork with the IRS.

Do I need earned income to open an IRA?

Yes, you must have earned income (wages from a job or self-employment income) to contribute to an IRA. If you are married and one spouse does not work, the working spouse can contribute to a spousal IRA for the non-working spouse, as long as the working spouse has enough earned income to cover both contributions.