An IRA is a savings account the government lets you use tax-free for retirement

An IRA stands for Individual Retirement Account. It is a bank or investment account where you set money aside for retirement, and the government gives you a tax break for doing it. The tax break is the whole point: money you put in may reduce what you owe in taxes that year, and the money grows without being taxed until you take it out in retirement.

Think of it this way. A regular savings account at your bank earns interest, but you pay taxes on that interest every year. An IRA earns interest or investment returns the same way, but you do not pay taxes on the growth while the money sits there. That tax delay means more of your money stays in the account working for you.

IRAs are not investments themselves. They are containers. Inside an IRA, you can hold a savings account, stocks, bonds, mutual funds, or other investments. The IRA is just the legal wrapper that gives you the tax benefit.

Key Takeaways

  • An IRA is a retirement savings account where your money grows without being taxed until you withdraw it, which gives you a tax advantage over a regular savings account.
  • You can only put in a limited amount each year (the limit changes annually), and you cannot take the money out before age 59½ without paying a penalty in most cases.
  • A Traditional IRA lets you deduct contributions from your taxes now, while a Roth IRA taxes you now but lets you withdraw tax-free in retirement.
  • You open an IRA at a bank, credit union, or investment firm, and you choose what to hold inside it.

Traditional IRA versus Roth IRA: the two main types

There are two common types of IRA, and they work in opposite directions on taxes. A Traditional IRA lets you put money in and deduct it from your income taxes that year. You pay taxes later, when you take the money out in retirement. A Roth IRA takes money that has already been taxed, but then you never pay taxes on it again — not on the growth, and not when you withdraw it.

Which one makes sense depends on whether you think you will be in a higher tax bracket now or in retirement. If you earn a lot now and expect to earn less in retirement, a Traditional IRA saves you money because you deduct a large amount now and pay taxes on smaller withdrawals later. If you earn less now and expect to earn more later, a Roth IRA is often better because you pay the lower tax rate now and avoid taxes on a larger amount later.

There is also a SEP IRA and a Solo 401(k) if you are self-employed or own a small business, but those are separate from the basic two. For someone new to retirement saving, Traditional or Roth is where to start.

Contribution limits: how much you can put in each year

The government sets a yearly limit on how much you can contribute to an IRA. The limit changes most years and depends on your age. For people under 50, the limit is one amount. For people 50 and older, the limit is higher to let you catch up on retirement saving.

You can find the current year's limit on the IRS website or by asking your bank or investment firm. The limit applies to all your IRAs combined — if you have both a Traditional and a Roth, your contributions to both together cannot exceed the yearly limit.

You can contribute less than the limit, or nothing at all in a given year. But you cannot carry unused contribution room forward to the next year. If you do not use it, you lose it.

When you can take money out without penalty

IRAs are meant for retirement, so the government discourages you from taking money out early. If you withdraw money before age 59½, you usually pay a 10 percent penalty on top of income taxes. That penalty is on top of the taxes you owe, not instead of them.

There are a few exceptions where you can take money out early without the 10 percent penalty. These include a first-time home purchase (up to $10,000 lifetime), certain medical expenses, disability, or a series of equal payments over your lifetime. But even with these exceptions, you still owe income taxes on the withdrawal. The penalty is just waived.

At age 73, the rules change again. You must start taking money out of a Traditional IRA whether you want to or not — these are called Required Minimum Distributions, or RMDs. Roth IRAs do not have this requirement during your lifetime, which is one reason some people prefer them.

Where to open an IRA and what to expect

You can open an IRA at almost any bank, credit union, or investment firm. Banks and credit unions often offer IRAs that hold savings accounts or CDs (Certificates of Deposit). Investment firms offer IRAs where you can buy stocks, bonds, or mutual funds. The choice depends on how much risk you want to take and how involved you want to be in managing the money.

Opening an IRA is straightforward. You go to the bank or firm's website or visit in person, fill out a form with your name, Social Security number, and address, and choose whether you want Traditional or Roth. You then decide how much to contribute and what to hold inside the account. The bank or firm will handle the paperwork and send you a confirmation.

There are no fees to open an IRA, though some banks or firms charge annual maintenance fees or fees when you buy and sell investments inside the account. Ask about fees before you open the account so there are no surprises.

How much your money can grow in an IRA

The growth depends on what you hold inside the IRA. If you hold a savings account, your money grows by the interest rate the bank pays. If you hold stocks or mutual funds, your money grows (or shrinks) based on how those investments perform. The advantage of the IRA is that this growth is not taxed while it sits in the account.

Over decades, that tax delay adds up. A straightforward example: if you put $5,000 in a regular savings account earning 4 percent interest, you pay taxes on the interest each year. In an IRA earning the same 4 percent, you do not pay taxes on the interest until you withdraw it, so more of the interest stays in the account earning more interest. That compounding effect is why IRAs are powerful for long-term retirement saving.

The actual growth depends on how much you contribute, how long the money sits there, and what returns your investments earn. There is no way to predict investment returns, but the longer your money has to grow, the more time compounding has to work.

IRA rules you need to know

IRAs come with rules beyond just contribution limits and withdrawal penalties. For a Traditional IRA, you can only deduct your contribution from your taxes if your income is below a certain level and you do not have a workplace retirement plan. If you earn above that level, you can still contribute, but you cannot deduct it. The IRS website lists the income limits for the current year.

For a Roth IRA, there are also income limits. If you earn above a certain amount, you cannot contribute directly to a Roth. However, there is a workaround called a "backdoor Roth" that lets higher earners contribute indirectly, though it is more complex and you may want to talk to a tax professional about it.

You can also move money between IRAs or from a workplace retirement plan into an IRA. This is called a rollover or transfer, and it has specific rules about timing and paperwork. If you change jobs and have a 401(k), you can often roll it into an IRA to keep it in one place.

Frequently Asked Questions

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

Yes, you can have both. Your yearly contribution limit applies to both combined, so if the limit is $7,000, you could put $4,000 in a Traditional IRA and $3,000 in a Roth, or any split that adds up to $7,000. Many people use both to split their tax benefits between now and retirement.

What happens to my IRA if I die?

Your IRA passes to whoever you named as a beneficiary on the account. That person can withdraw the money or, in some cases, keep it in an IRA and take withdrawals over time. If you did not name a beneficiary, the money goes through your estate, which is slower and more complicated. Name a beneficiary when you open the account.

Can I use my IRA to buy a house?

You can withdraw up to $10,000 lifetime from a Traditional or Roth IRA for a first-time home purchase without the 10 percent early withdrawal penalty. You still owe income taxes on the withdrawal. If you need more than $10,000, you have to pay the penalty on the rest.

Do I need a job to open an IRA?

You need to have earned income in the year you contribute. That can be from a job, self-employment, or freelance work. You cannot contribute to an IRA using only investment income, Social Security, or money from a spouse's income, though there are exceptions for spouses in some cases.

What is the difference between an IRA and a 401(k)?

An IRA is individual and you open it yourself. A 401(k) is offered by your employer. 401(k)s usually have higher contribution limits and some employers match your contributions. IRAs are more portable — you keep them if you change jobs. Both offer tax advantages, but they work differently and have different rules.