What an IRA actually does

An IRA (Individual Retirement Account) is a container the government lets you use to save money for retirement with tax advantages. You open it at a bank, credit union, or brokerage firm. You put money in. That money grows over time. When you reach retirement age, you take money out. The tax advantage is the part that makes it different from a regular savings account — the government either lets you deduct what you put in from your taxes now, or lets the money grow without being taxed until you withdraw it later.

The IRA itself does not invest your money or make decisions. You do. Once you open an IRA, you decide what to do with the cash inside it — leave it in a savings account, buy stocks, buy bonds, buy mutual funds, or some combination. The IRA is just the legal wrapper that gives you the tax benefit.

There are two main types: a Traditional IRA and a Roth IRA. They work differently in terms of when you pay taxes and when you can take money out. Most people have one or the other, not both, though you can have both if you want.

Key Takeaways

  • An IRA is a retirement savings account where you choose how to invest the money inside, and the government gives you a tax break for using it.
  • A Traditional IRA lets you deduct contributions from your taxes now, but you pay taxes when you withdraw money in retirement.
  • A Roth IRA takes after-tax money now, but withdrawals in retirement are tax-free.
  • You cannot withdraw money before age 59½ without a penalty, with a few narrow exceptions.
  • You open an IRA at a bank, credit union, or brokerage, and you control what happens to the money inside.

Traditional IRA: Tax deduction now, taxes later

With a Traditional IRA, you put money in and deduct that amount from your taxable income for the year. If you earn $50,000 and put $6,500 into a Traditional IRA, you only report $43,500 as taxable income. That means you pay less in taxes that year.

The catch: when you withdraw that money in retirement, you pay income tax on it. The money grew tax-free inside the account, but the withdrawals are taxed as ordinary income. If you withdraw $30,000 in a year, that $30,000 counts as income for that year, and you owe taxes on it.

You can start withdrawing without penalty at age 59½. If you withdraw before that age, you owe a 10% penalty on top of the income tax, with some exceptions (like a first-time home purchase up to $10,000, or certain medical expenses). At age 73, you must start taking withdrawals whether you want to or not — the government calls this a Required Minimum Distribution, or RMD. The amount depends on your age and account balance.

Roth IRA: No tax deduction now, tax-free withdrawals later

A Roth IRA works backward. You put money in using after-tax dollars — money you have already paid income tax on. You do not get a tax deduction. But when you withdraw in retirement, you owe no taxes on the money or the growth.

If you put $6,500 into a Roth IRA, you cannot deduct it from your taxes that year. But if that $6,500 grows to $20,000 over 30 years, you withdraw the full $20,000 tax-free in retirement. You only pay taxes once, upfront, instead of twice.

You can withdraw your contributions (the money you put in) at any time without penalty. You can only withdraw the growth penalty-free after age 59½ and if the account has been open for at least five years. Unlike a Traditional IRA, there is no Required Minimum Distribution — you can leave the money in the account as long as you want.

Roth IRAs have income limits. If you earn above a certain amount, you cannot contribute directly to a Roth. The income limit varies by year and filing status, so check the current year's limit before opening one.

Contribution limits and how much you can put in

The government sets a yearly limit on how much you can put into an IRA. For 2024, that limit is $7,000 per year if you are under age 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 current year before you contribute.

The limit applies across all your IRAs combined. If you have both a Traditional IRA and a Roth IRA, your total contributions to both cannot exceed the yearly limit. You can split the money however you want — $4,000 in one and $3,000 in the other, for example — but the total is capped.

You can only contribute money you actually earned from work. You cannot contribute to an IRA using investment gains, inheritance, or gifts (though someone can gift you money and you can then contribute it if you have earned income).

How to open an IRA and where to open it

You open an IRA the same way you open a regular bank account. You go to a bank, credit union, or brokerage firm, fill out paperwork (now often online), and choose whether you want a Traditional or Roth IRA. The institution will ask for your Social Security number, address, and employment information.

Banks and credit unions typically offer IRAs that hold savings accounts or CDs (Certificates of Deposit). A brokerage firm offers IRAs where you can buy stocks, bonds, mutual funds, or exchange-traded funds. Some brokerages let you do both — hold cash and also buy investments.

There is no single "best" place to open an IRA. Compare what each institution charges in fees, what investment options they offer, and whether you want to work with someone in person or online. Many people open IRAs at the same bank or brokerage where they already have a checking account.

What happens to an IRA when you retire

Once you reach age 59½, you can withdraw money from your IRA without the 10% early withdrawal penalty. You still owe income tax on Traditional IRA withdrawals, but not the penalty. With a Roth IRA, you owe no taxes if the account is at least five years old.

You do not have to withdraw a specific amount each year — you can take out as much or as little as you want, whenever you want. Some people withdraw a steady amount each month. Others take larger withdrawals in years when they have lower income. It is your choice.

If you have a Traditional IRA, the government requires you to start taking withdrawals at age 73. The amount is calculated based on your age and account balance, and the IRS publishes tables to help you figure it out. If you do not take the required amount, you owe a penalty on the shortfall.

IRAs and taxes: the basic math

The main reason people use IRAs is the tax advantage. A Traditional IRA saves you taxes now. A Roth IRA saves you taxes later. Which one makes sense depends on whether you think your tax rate will be higher or lower in retirement than it is now.

If you are young and expect to earn more money over time, a Roth might make sense — you pay taxes at a lower rate now, and avoid higher taxes later. If you are older and expect to earn less in retirement, a Traditional IRA might make sense — you deduct contributions when your income is high, and pay taxes on withdrawals when your income is lower.

This is not a hard rule, and tax situations are individual. Many people benefit from having both types of accounts. The point is that the tax treatment is the main difference between them, and it is worth thinking about before you choose.

Frequently Asked Questions

Can I have both a Traditional IRA and a Roth IRA at the same time?

Yes. Your yearly contribution limit applies to both combined, so if you put $4,000 in a Traditional IRA, you can only put $3,000 in a Roth that year (assuming the $7,000 limit). Many people use both — a Traditional IRA for pre-tax contributions and a Roth for after-tax contributions.

What happens to my IRA if I change jobs?

Your IRA stays yours. It is not connected to your employer. You keep contributing to it, and it keeps growing. If your new job offers a 401(k) or similar plan, you can have both the IRA and the workplace plan at the same time.

Can I withdraw money from my IRA before age 59½?

You can, but you will owe a 10% penalty plus income tax on the withdrawal. Exceptions exist for first-time home purchases (up to $10,000), certain medical expenses, and a few other situations. With a Roth IRA, you can withdraw your contributions anytime without penalty, just not the growth.

What if I do not use all my contribution room in a year?

You cannot carry it forward. If you do not contribute the full $7,000 in a year, you lose that year's contribution room. You can only contribute up to the limit for the current year.

Do I need earned income to open an IRA?

Yes. You can only contribute to an IRA if you earned income from work that year. If you are retired or do not work, you cannot contribute. A spouse with no income can sometimes contribute if the working spouse has enough earned income, depending on the type of IRA.