What is an IRA?
An Individual Retirement Account (IRA) is a retirement savings account with tax benefits. There are four main types of IRAs: Traditional IRA, Roth IRA, SEP IRA and SIMPLE IRA.
But there are also these types of IRAs: backdoor Roth, spousal, self-directed, inherited and rollover.
That's a lot, but this guide will help you understand what you need to know to get started.
How an IRA works
Here are the general concepts to know.
You invest the money that's in your IRA. You can invest in stocks, bonds and other assets. For a long-term goal like retirement, we generally recommend stocks and bonds because of their higher returns. (See how to invest your IRA for simple investment tips.)
You can open an account at a bank or a broker. With a broker, you’ll be able to invest in stocks and bonds, while banks generally offer Certificates of Deposit and savings accounts. For a long-term goal like retirement, we generally recommend stocks and bonds because of their higher returns.
Working people can add money to their accounts every year. Generally, you (or your spouse) must have earned income to contribute to an IRA.
There's a limit to how much you can contribute every year. Two of the most popular types of accounts — the traditional and the Roth — allow you to save $6,000 per year ($7,000 if you’re 50 or older), even if you’re also contributing to a 401(k) or other workplace savings plan. Those annual contribution limits are the same for both 2020 and 2019.
The withdrawal rules do let you withdraw your money any time, but you may face a 10% penalty and a tax bill if you take out your money before age 59 1/2, unless you qualify for an exception. Read on for more details on withdrawal rules. (Note: COVID-19 relief efforts changed the rules for retirement distributions in 2020. Get the details here.)
IRAs, taxes and you
From a tax perspective, the main draws of an IRA are that you might be able to deduct your contributions on your taxes, and the gains and dividends aren't taxable while the money is in the account. But there can be other tax perks (and pitfalls), too.
With a traditional IRA, contributions can reduce your tax bill in the year you contribute (if you qualify for that tax break), and you won’t owe income taxes until you withdraw the money in retirement.
With a Roth, contributions are not tax-deductible, but your investments grow tax-free and you can withdraw money tax-free in retirement. Also, you might not be able to contribute to a Roth if your income is over certain limits.
A backdoor Roth is a way to open a Roth even if you exceed the income limits.
You might be able to take the Saver's Credit for contributing to an IRA.
See below for more details about these and other IRAs.
» Ready to get started? These are our top picks for the best IRA accounts
Types of IRAs
There are four main types: traditional, Roth, SEP and SIMPLE.
Here are the general rules.
With a traditional IRA, you might be able to deduct the amount of your contributions on your tax return. That means a smaller tax bill.
Your money grows tax-deferred. You won’t owe income taxes until you withdraw the money from your account.
Anyone — regardless of income — can contribute to a traditional IRA. But the amount you can to deduct from your taxes depends on your income if you or your spouse has access to a retirement plan at work. If you (and your spouse) don't have a retirement plan at work, generally you can take a full deduction for your traditional IRA contribution, up to your maximum contribution level. If you have a retirement plan at work, then check out the 2019 and 2020 IRA deduction limits below. If you don't have a workplace retirement plan but your spouse does, see the separate income limit for that situation.
Traditional IRA income limits for 2019 and 2020, if you have a retirement plan at work
If you’re eager to get an upfront tax break today, a traditional IRA may be a good choice. Or, if you expect to pay a lower tax rate in retirement, then delaying the tax bill until then makes sense.
Keep in mind that to avoid a withdrawal penalty, you'll need to be age 59 ½ or meet some specific exceptions — see traditional IRA withdrawals for details.
If you’ve got the willpower to wait to get your tax break, a Roth can be an especially attractive option.
The contributions are not tax-deductible, but your money grows tax-free — you never owe taxes on the investment gains in your account .
You can withdraw money tax-free in retirement. (With a traditional IRA, you pay taxes on both your contributions and earnings when you withdraw money.)
The Roth comes with another big perk: You can take out money you contributed to a Roth at any time without penalty. But there are rules about early withdrawals of investment earnings and other transferred funds — see Roth IRA withdrawals for details.
There are income limits that prevent higher earners from contributing to Roths. (However, in that situation, a backdoor Roth is another option — more on that below.)
Here are the Roth contribution limits for 2019 and 2020. Note: The income limits apply to your modified adjusted gross income (MAGI), which is your adjusted gross income with some deductions and exclusions added back in. See IRS Publication 590-A, Worksheet 2-1, for complete instructions on figuring MAGI for Roth IRAs.
Roth income limits for 2019 and 2020
SEP stands for “simplified employee pension.” These accounts are a useful retirement savings tool for small-business owners and self-employed people.
A SEP IRA offers a tax deduction on contributions.
Your savings grow tax-deferred, and withdrawals in retirement are taxed at regular income tax rates.
If you have eligible employees, the IRS requires you to contribute to their accounts at the same rate that you contribute to your account. For example, if you’re saving 10% of your compensation, then you must contribute the same percentage of employees’ compensation to their accounts. Employees generally can’t contribute to a SEP (though some SEP IRAs allow for traditional IRA contributions).
The big appeal of these accounts for business owners is that the maximum annual contribution is $57,000 in 2020 (up from $56,000 in 2019), much higher than the $6,000 max for traditional IRAs. One caveat: You can’t contribute more than 25% of compensation. Read more about SEP IRAs.
SIMPLE IRAs are retirement savings accounts for small companies, generally with 100 or fewer employees.
Compared with a 401(k), a SIMPLE IRA is relatively easy for employers to set up. (SIMPLE stands for Savings Incentive Match Plan for Employees.)
Employers are required to contribute to the plan, based on specific IRS rules. And, unlike a SEP, with a SIMPLE employees can contribute their own money, up to $13,500 in 2020 (up from $13,000 in 2019), plus an extra $3,000 catch-up contribution for people 50 and older.
The amount employees contribute will reduce their taxable income for the year, and their money will grow tax-deferred until they withdraw it in retirement, at which point income taxes apply on withdrawals. Read more about SIMPLE IRAs.
Other types of IRAs
If your income priced you out of making Roth contributions, fear not. You can still open a Roth, thanks to the backdoor Roth option. (The name “backdoor Roth” is not an official account name; it describes a tax strategy.)
Put simply, you open a traditional IRA and then convert it to a Roth. Ideally, your traditional IRA accounts — the one you want to convert plus other traditional IRAs you might have — consist entirely of nondeductible contributions. If not, be prepared for a tax bill. The IRS’s pro-rata rule means that if you have traditional IRA contributions for which you’ve taken a tax deduction, even if those contributions are in another traditional IRA account, some portion of the money you convert to the Roth likely will be taxable. Read more about backdoor Roths.
Generally, to contribute to an IRA, you need to have earned income. A spousal IRA is one exception to that rule: these accounts let spouses who don’t work for pay contribute to either a traditional or Roth, based on their working spouse’s income.
The spousal IRA is owned by the non-working spouse, and the maximum contribution is $6,000 ($7,000 if 50 or older). But there’s another limit: the total contributions of both spouses to each of their IRAs can’t exceed the working spouse’s earned income. Read more about spousal IRAs.
Technically, almost all IRAs are self-directed, in that you choose your own investments for the account. But “self-directed” has come to describe a special type of IRA: one that lets you invest in alternative investments, such as real estate or a privately-held company. You’ll need to find a custodian who’s willing to let you do that — the brokers that are household names generally don’t offer self-directed IRAs.
Self-directed IRAs can come in the traditional or Roth flavor, and they have the same income and eligibility rules. The only difference is the type of investments you own in the account. Read more about self-directed IRAs.
An inherited IRA, also known as a beneficiary IRA, comes with some very specific rules — and you want to follow them so you avoid a big tax bill. Keep in mind that the rules vary depending on your relationship with the deceased person. Read more about inherited IRAs.
A rollover IRA is an individual retirement account created by transferring money from a 401(k) or other retirement account. A major benefit is that it keeps your retirement dollars safe from taxes when the process is done correctly. Read more about rollover IRAs.
How to open an IRA account
Before choosing a provider, ask yourself how involved you want to be in the management of your investments:
If you want to choose investments for yourself, an online brokerage is a good way to go. Review our best IRA accounts to compare.
If you want help managing your retirement account, consider a robo-advisor — a service that selects low-cost and risk-appropriate investments for you. See our list of best robo-advisors for help choosing the right one for you.
Once you have chosen a provider, the online signup process is pretty simple: You'll be asked to provide some general information, including Social Security number, birthdate, contact information and employment details. See our guide to opening an IRA for more information on moving money into your account.
Here are some of our top picks for best IRA accounts: