An IRA gives you tax breaks on money you save for retirement

An IRA (Individual Retirement Account) is a savings account with tax advantages built in. The main benefit is this: money you put in may reduce your taxable income for the year, and the money inside grows without being taxed each year. When you withdraw it in retirement, you pay taxes then—but often at a lower rate than you would have paid on the income when you earned it.

There are two main types: a Traditional IRA and a Roth IRA. They work differently, and which one makes sense depends on your income now versus what you expect in retirement. Both let you invest the money in stocks, bonds, mutual funds, or other investments—you are not stuck with a savings account earning almost nothing.

The catch is that IRAs are meant for retirement. If you take money out before age 59½, you usually pay a 10 percent penalty on top of income taxes. There are a few exceptions (first-time home purchase, medical hardship, disability), but they are narrow. The account is designed to stay untouched until you retire.

Key Takeaways

  • A Traditional IRA lets you deduct contributions from your taxable income in the year you make them, lowering what you owe in taxes that year.
  • A Roth IRA takes after-tax money now but grows tax-free, and you withdraw it tax-free in retirement—useful if you expect to be in a higher tax bracket later.
  • Money inside an IRA is not taxed each year as it grows, so compound growth happens faster than in a regular savings or investment account.
  • Withdrawals before age 59½ trigger a 10 percent penalty plus income taxes, so IRAs work best for people who can leave the money alone until retirement.
  • You can only contribute money you actually earned that year—you cannot put in more than you made, and contribution limits reset each January.

How a Traditional IRA reduces your taxes right now

With a Traditional IRA, you contribute money and deduct it from your income on your tax return. If you earned $50,000 and put $5,000 into a Traditional IRA, you report only $45,000 as taxable income. That means you pay income tax on $45,000 instead of $50,000.

This works if your income is below certain thresholds. If you have a workplace retirement plan (like a 401(k)) and earn above those thresholds, the deduction phases out or disappears. Your bank or tax software will tell you whether you can deduct the full amount, a partial amount, or nothing. The income limits change each year.

The money you put in grows inside the account without being taxed each year. When you turn 59½ and start withdrawing, you pay income tax on what you take out. The idea is that you will be in a lower tax bracket in retirement than you are now, so you pay less tax overall.

How a Roth IRA works backward—tax-free growth instead of an upfront deduction

A Roth IRA does not give you a tax deduction when you contribute. You put in after-tax money—money you have already paid income tax on. But then the money grows inside the account tax-free, and when you withdraw it in retirement, you owe no taxes at all.

This is useful if you think your tax rate will be higher in retirement than it is now. It is also useful if you are young and expect your income to rise significantly, because Roth contributions have income limits too. Once your income exceeds the limit, you cannot contribute to a Roth directly (though there are workarounds called "backdoor Roth" conversions that some people use).

A Roth also has a hidden benefit: you can withdraw your contributions (not the growth) at any time without penalty. If you put in $5,000 and it grows to $7,000, you can take out the $5,000 anytime. You cannot touch the $2,000 in growth without the 10 percent penalty and taxes, but the contributions are yours. This makes a Roth slightly more flexible if an emergency happens.

Your money grows without annual taxes eating into it

In a regular savings or investment account, you pay taxes on interest, dividends, and capital gains each year. If you earn $500 in dividends, you owe taxes on that $500 that year. If you earn $500 in gains the next year, you owe taxes on that too. Over decades, those annual tax bills add up and reduce how much compound growth you get.

Inside an IRA, none of that happens. You earn dividends, interest, or gains, and the full amount stays in the account and keeps growing. You do not file a tax form for the IRA each year. The taxes are deferred (in a Traditional IRA) or eliminated (in a Roth IRA), so more of your money works for you instead of going to taxes.

This tax-sheltered growth is one of the biggest reasons people use IRAs. Over 30 or 40 years, the difference between paying taxes annually and paying them once in retirement can be tens of thousands of dollars.

Contribution limits mean you cannot put in unlimited money

The IRS sets a maximum you can contribute to 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 occasionally, and your bank or tax software will show you the current year's limit.

You can only contribute money you earned that year. If you made $3,000 in income, you cannot put $7,000 into an IRA—you can only put in $3,000. If you are married and file jointly, your spouse can have their own IRA with their own limit based on their income.

If you exceed the limit, the IRS charges a 6 percent penalty each year on the excess amount until you remove it. It is not a huge penalty, but it is annoying, so most people track their contributions carefully or use their bank's tools to stay within the limit.

You cannot touch the money penalty-free until age 59½

This is the main trade-off. In exchange for the tax benefits, the IRS locks the money away. If you withdraw before 59½, you pay a 10 percent penalty on the amount withdrawn plus income taxes on it. A $10,000 withdrawal might cost you $1,000 in penalty plus $2,000 to $3,000 in taxes, depending on your tax bracket.

There are exceptions. You can withdraw without penalty if you are disabled, if you have significant medical expenses, if you are a first-time homebuyer (up to $10,000 lifetime), or if you are taking substantially equal periodic payments (a complex rule for people who retire early). But these are narrow. For most people, the money needs to stay put.

This is why an IRA works best if you have other savings for emergencies and shorter-term goals. Your IRA should be money you genuinely will not need for decades.

IRAs work alongside workplace retirement plans, not instead of them

If your employer offers a 401(k), 403(b), or similar plan, you can have both that plan and an IRA. Many people do. The advantage of a workplace plan is that your employer may match your contributions (assistance programs), and the contribution limits are much higher—$23,500 in 2024 versus $7,000 for an IRA.

If you have a workplace plan, the IRA deduction phases out at higher incomes. You can still contribute to an IRA, but you may not be able to deduct it. A Roth IRA has its own income limits too. Your tax software or a tax preparer can tell you what you are allowed to do based on your specific situation.

The strategy most people follow is to contribute enough to their workplace plan to get the full employer match, then max out an IRA if they can, then put extra money back into the workplace plan if they have it left over.

Frequently Asked Questions

Can I have both a Traditional IRA and a Roth IRA?

Yes, you can have both. However, your total contributions to both accounts combined cannot exceed the annual limit ($7,000 in 2024 if you are under 50). If you put $4,000 into a Traditional IRA, you can only put $3,000 into a Roth that year. The limits are combined, not separate.

What happens to my IRA if I change jobs?

Your IRA stays with your bank or investment company—it is not tied to your employer. You can keep it where it is, move it to a different bank, or roll it into your new employer's retirement plan if they allow it. The money is yours regardless of where you work.

Do I have to withdraw money from my IRA at a certain age?

Yes. Starting at age 73 (as of 2023), you must take required minimum distributions (RMDs) from a Traditional IRA each year. Roth IRAs do not require withdrawals during your lifetime. If you do not take the RMD, the IRS charges a 25 percent penalty on the amount you should have withdrawn.

Can I invest my IRA in anything I want?

Almost anything: stocks, bonds, mutual funds, ETFs, CDs. You cannot invest in collectibles (art, wine, coins), life insurance, or certain other items. Your bank or investment company will show you what options are available in their IRA accounts.

What if I need money before retirement—is there any way to access it?

The main penalty-free exception is the first-time homebuyer rule: you can withdraw up to $10,000 lifetime from a Traditional IRA to buy a home. With a Roth, you can withdraw your contributions anytime without penalty, just not the growth. Otherwise, early withdrawal means the 10 percent penalty plus taxes.