Investing

What Is an IRA? How IRAs Work & How to Get Started

An Individual Retirement Account (IRA) offers valuable tax benefits for retirement savers. Here's how IRAs work.

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What is an IRA? In a nutshell, it lets you save money for retirement and get tax breaks for doing so.

What is an IRA?

An individual retirement account (IRA) is a type of tax-deferred or tax-free retirement account that individuals can open at many financial institutions.

There are three main types of IRAs:

  1. Traditional: An IRA in which investments grow tax-deferred and contributions can be tax-deductible.

  2. Roth: An IRA in which money grows tax-free; withdrawals in retirement are also tax-free.

  3. Rollover: An IRA created by transferring money from a 401(k) or other retirement account.

But there are other types of IRAs, too, including backdoor Roth, spousal, self-directed, inherited, SEP and SIMPLE. They all have different advantages. This guide will help you understand what you need to know to get started.

Is an IRA and 401k the same thing?

No. Both help you save for retirement, but employers offer 401(k)s, while IRA accounts are opened by individuals (typically you go to a broker or a bank to open an IRA account). If you're not sure whether to put money in a 401(k) versus an IRA, this can help.

How IRAs work

Here are the key characteristics of IRAs and general concepts.

  • You open an IRA at a bank, robo-adisor or a broker. If you get one from a broker or robo-advisor, you’ll be able to invest in stocks and bonds; IRAs from banks generally offer Certificates of Deposit and savings accounts.

» Ready to get started? These are our top picks for the best IRA accounts

  • You invest the money in the account. You can invest in stocks, bonds and other assets. How much your account grows per year and whether you lose money depends on how you invest. For a long-term goal like retirement, stocks and bonds can be a sensible choice because of their higher historical returns. (See how to invest your IRA for simple investment tips.)

  • Contribution limits. Two of the most popular types of accounts — the traditional and the Roth — allow you to add $6,000 per year in 2020 ($7,000 if you’re 50 or older), even if you’re also contributing to a 401(k) or other workplace savings plan. Generally, you (or your spouse) must have earned income to contribute to an IRA.

  • Withdrawal rules. You may face a 10% penalty and a tax bill if you withdraw money before age 59 1/2, unless you qualify for an exception. (Note: COVID-19 relief efforts changed the rules for retirement distributions in 2020. Get the details here.) See below for more details.

Here's how to open an IRA account

Two popular ways to get an IRA are through brokers and robo-advisors.

  • Brokers: If you want to choose investments for yourself, an online broker can be a good way to go. Review our best IRA accounts to compare.

  • Robo-advisors: 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.

See our guide to opening an IRA for more information on moving money into your account.

Why invest in an IRA?

You're going to need income during retirement, and having money in an IRA is a way to make that happen. You may not be able to sock away everything you need in a 401(k) or other employer plan, which is why an IRA can be handy. Investing in an IRA can also help manage your tax bill and give you access to a wider range of investment choices.

Tax advantages of IRAs

From a tax perspective, here are the main draws.

  • Traditional: You may be able to deduct your contributions, which can reduce your tax bill in the year you contribute. Also, you won’t owe income taxes until you withdraw the money in retirement (if you expect to pay a lower tax rate in retirement, then delaying the tax bill until then makes sense). To avoid a withdrawal penalty, you'll need to be age 59 ½ or meet some specific exceptions — see traditional IRA withdrawals for details.

  • Roth: You can't deduct your contributions, but your investments grow tax-free and you can withdraw money tax-free in retirement.

  • You might be able to take the Saver's Credit for contributing to an IRA.

Types of IRAs

Here's a quick overview of the two most popular ones.

ROTH IRA

TRADITIONAL IRA

Contribution limit

$6,000; $7,000 for those 50 and above.

$6,000; $7,000 for those 50 and above.

Key pros

  • Qualified withdrawals in retirement are tax-free.

  • Contributions can be withdrawn at any time.

  • If deductible, contributions reduce taxable income in the year they are made.

Key cons

  • No immediate tax benefit for contributing.

  • Ability to contribute is phased out at higher incomes.

  • Deductions may be phased out.

  • Distributions in retirement are taxed as ordinary income.

Early withdrawal rules

  • Contributions can be withdrawn at any time, tax- and penalty-free.

  • Unless you meet an exception, early withdrawals of earnings may be subject to a 10% penalty and income taxes.

  • Unless you meet an exception, early withdrawals of contributions and earnings are taxed and subject to a 10% penalty.

Traditional

A traditional IRA is an individual retirement account in which investments grow tax-deferred and contributions can be tax-deductible. Here's how a traditional IRA works.

  • No income cap. Anyone — regardless of income — can contribute to a traditional IRA account.

  • Contributions may be deductible on your taxes. How much you can deduct depends on your income if you or your spouse have 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 contribution, up to your maximum contribution level. If you do have a retirement plan at work, then check out the 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.

  • Money grows tax-deferred. You won’t owe income taxes until you withdraw the money from your account. In other words, you pay taxes on both your contributions and earnings when you withdraw the money.

Traditional income limits if you have a retirement plan at work

Filing status

2019 MAGI

2020 MAGI

Deduction

Single or head of household

$64,000 or less

$65,000 or less

Full deduction

More than $64,000 but less than $74,000

More than $65,000 but less than $75,000

Partial deduction

$74,000 or more

$75,000 or more

No deduction

Married filing jointly

$103,000 or less

$104,000 or less

Full deduction

More than $103,000 but less than $123,000

More than $104,000 but less than $124,000

Partial deduction

$123,000 or more

$124,000 or more

No deduction

Married filing jointly (spouse covered by retirement plan at work)

$193,000 or less

$196,000 or less

Full deduction

More than $193,000 but less than $203,000

More than $196,000 but less than $206,000

Partial deduction

$203,000 or more

$206,000 or more

No deduction

Married filing separately (you or spouse covered by retirement plan at work)

Less than $10,000

Less than $10,000

Partial deduction

$10,000 or more

$10,000 or more

No deduction

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 1-1, for complete instructions on figuring MAGI for traditional IRAs.

Roth

A Roth IRA is an individual retirement account in which money grows tax-free; withdrawals in retirement are also tax-free. Here's how a Roth works.

  • There's an income cap. Income limits prevent higher earners from contributing to Roths. (However, in that situation, a backdoor Roth is another option — more on that below.)

  • Contributions are not deductible. There's no tax deduction in the year you contribute to a Roth.

  • Money grows tax-free. You never owe taxes on the investment gains in your account. That means you can withdraw money tax-free in retirement. (With a traditional IRA account, you pay taxes on both your contributions and earnings when you withdraw money.)

  • Withdrawal flexibility. The Roth comes with another big perk: You can take out the 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 withdrawals for details.

Roth income limits

Filing status

2019 MAGI

2020 MAGI

Maximum annual contribution

Single, head of household or married filing separately (if you didn't live with spouse during year)

Less than $122,000

Less than $124,000

$6,000 ($7,000 if 50 or older)

$122,000 up to $137,000

$124,000 up to $139,000

Contribution is reduced

$137,000 or more

$139,000 or more

No contribution allowed

Married filing jointly or qualifying widow(er)

Less than $193,000

Less than $196,000

$6,000 ($7,000 if 50 or older)

$193,000 up to $203,000

$196,000 up to $206,000

Contribution is reduced

$203,000 or more

$206,000 or more

No contribution allowed

Married filing separately (if you lived with spouse at any time during year)

Less than $10,000

Less than $10,000

Contribution is reduced

$10,000 or more

$10,000 or more

No contribution allowed

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 Roths.

Other types of IRAs

Rollover

A rollover 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.

Backdoor Roth

A backdoor Roth is a way to open a Roth even if you exceed the income limits.

  • Put simply, you open a traditional IRA and then convert it to a Roth.

  • Ideally, your traditional IRA account — the one you want to convert plus other traditional IRAs you might have — consists 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 account 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.

SEP

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, 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

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, 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.

Spousal

Generally, to contribute to an IRA account, you need to have earned income. A spousal IRA is an 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).

  • 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.

Self-directed

Technically, almost all IRAs are self-directed, in that you choose your own investments for the account. But “self-directed” describes an IRA 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.

Inherited

An inherited IRA account, 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.

Can you lose money in an IRA?

It is possible to lose money in an IRA. Much of it depends on how you invest your money. If you’re investing in the stock market, there will be times your account balance may dip when the market does what it’s historically done over short periods of time: seesaw between highs and lows. Over the long term, however, investing in the stock market may give you the biggest bang for your buck. Often, the key to ensuring any losses are just temporary is to stay the course. Having a long-term investing time horizon and the temperament to weather the storm are how fortunes are made.

ira

FAQs

It’s undoubtedly a good investment vehicle, but it’s not technically an investment in and of itself: An IRA is a type of account that holds your investments, just like a bank account is a holding pen for your cash. The amount of money you earn in an IRA is based on the investments held in the account.

While you can certainly hold cash in your IRA, the purpose of the account is to achieve better investment returns than you’d get by placing that money into a savings account at your bank.

If you have a decade or more until you retire, allocating a significant portion of your IRA to stocks can help support higher long-term returns. Specifically, we’re talking about investment vehicles like mutual funds and exchange-traded funds (ETFs) that provide exposure to the stock market. The stock market’s average return has historically been far higher than what you’d earn with bonds, a certificate of deposit or even a high-yield savings account.

Here’s a four-step plan for choosing investments for your IRA.

Thank you for asking and allowing us to clear up a common misconception: An IRA is not technically an investment. It’s merely an account, albeit a special tax-sheltered account, that enables savers to hold whatever investments you choose — hence, those choices will impact your IRA’s performance more so than the place you go to open it.

That said, there is merit in asking where the best place is to open an IRA. You can whittle down the universe of dozens of potential IRA providers based on how involved you want to be in managing your account:

If you want to choose and manage your investments, you’ll need an online broker. An online brokerage account allows you to buy and sell investments you choose and manage your retirement portfolio on your own.

When we evaluate brokers, we’re looking for ones that charge low or no account fees, and reasonable commissions; offer a wide selection of no-transaction-fee mutual funds and commission-free exchange-traded funds; and provide solid customer support and educational resources. You also want to make sure that the broker offers the investments you need. You can buy most stocks at any broker, but their mutual fund lineups can vary, and not all brokers carry funds from all providers.

If you’d like an automated way to manage your investments, consider a robo-advisor. A robo-advisor chooses low-cost mutual funds and ETFs (exchange-traded funds) that align with your investing preferences and timeline. Their services cost a fraction of what a human financial manager typically charges.

When shopping for a robo-advisor you want to look for one with a low management fee — generally 0.40% or less — and services that meet your needs (such as access to human financial advisors or banking services). Automatic rebalancing and portfolio allocation are standard offerings with most robo-advisors.

» MORE: See which discount brokers and robo-advisors are standouts in our list of the best IRA accounts.

Both IRAs and 401(k)s are retirement savings accounts, and both offer tax breaks as an incentive to sock away money for your future. But 401(k)s are available only through an employer (in technical IRS language, they're employer-sponsored retirement plans) while an IRA can be set up by any individual who has earned income.

Other noteworthy differences:

- 401(k)s have higher annual contribution limits than IRAs: $19,500 in 2020 versus $6,000 in an IRA. - Catch-up contribution limits are also beefier in workplace plans: If you’re age 50 or older, the IRS allows you to save an additional $6,500 in 2020 in a 401(k). The maximum annual catch-up contribution allowed in an IRA is $1,000. - You have until the tax filing deadline in April of the following year to make contributions to an IRA. Contributions to a 401(k) must be made by Dec. 31 in order to qualify for the current tax year. - Some 401(k)s have a vesting period where employees have to wait a certain period of time before they’re allowed to participate in the plan. There’s no vesting period with an IRA. - Some employers sweeten the pot with 401(k)s and kick in their own money to match a portion of what employees save. That extra money may be subject to a vesting period. - Investment offerings in a 401(k) are determined by the plan administrator. In an IRA the choices are much broader: If you choose to open an account at a discount brokerage you can pick from mutual funds, exchange-traded funds (ETFs), stocks and more.

If you’re wondering if it’s better to have a 401(k) or an IRA, here’s some good news: You don’t have to choose. The IRS allows savers to contribute to both an IRA and a 401(k) at the same time. And if you leave your company, you can take the money with you and roll it over into an IRA. (Here’s how to do a rollover IRA.)

Our advice: If your 401(k) offers an employer match, invest enough to get the full match. After that, direct your retirement savings dollars into a Roth or traditional IRA to take advantage of the more expansive line-up of investments.

Here’s a more detailed take on the IRA vs. 401(k) question, including a simple plan for how to maximize your returns and minimize your costs.

Once you’ve set up your account — deposited money and indicated which type of IRA you want — it’s time to select investments. If you do nothing, your money will sit in cash. However, as we said earlier, cash isn’t an ideal investment when saving for a long-term goal like retirement.

If you set up an IRA at a discount broker, you have an array of investment options, including individual stocks, bonds and mutual funds. Simply indicate what you want to purchase and the broker will facilitate the trade as long as you’ve deposited enough money in the account to cover the cost of any commission plus the price of a single share of a stock or ETF. If you’re purchasing a mutual fund, you’ll need an account balance that can meet the minimum investment requirement for a mutual fund as well as any commission. (See more on how to invest in mutual funds.)

Before your money is invested by a robo-advisor, you’ll be asked to complete a brief questionnaire about your investing goals, time frame (when you'll need the money) and your tolerance for risk. The robo-advisor will make investment recommendations — a mix of mutual funds and exchange-traded funds (ETFs) — based on your answers. You’ll be given the opportunity to review the recommendations and then the money will be invested accordingly.

Here’s more on how to invest your IRA.

Yes, but not always without consequences. Ideally, you should let that money marinate in the account until you’re at least age 59 ½. Any earlier and you may trigger a hefty income tax bill as well as a 10% early withdrawal penalty.

That said, if you absolutely must access the money before then, Roth IRA early withdrawal rules are a lot more lenient than those for traditional IRAs.

You can tap into your Roth IRA contributions at any time and for any reason without paying any taxes or penalties. That’s because a Roth is funded with after-tax dollars and the IRS already got its cut. Roth IRA earnings are another matter: Early distributions of investment earnings before the account is at least five years old will be accompanied by taxes and penalties, with a few exceptions. (Read more on Roth IRA early withdrawal rules.)

Early withdrawals from a traditional IRA — again, before age 59 ½ — will likely be taxed and penalized 10%. Some exceptions to the 10% penalty are using IRA money to pay for higher-education expenses, a first home purchase (limited to a $10,000 withdrawal), and unreimbursed medical expenses that exceed 7.5% of your adjusted gross income. (Read more on traditional IRA early withdrawal rules.)

Contributions to a traditional IRA can immediately reduce your taxable income dollar-for-dollar up to the contribution maximum ($6,000 in both 2020 and 2019). That means if you earned $50,000 and maxed out an IRA, you’d only owe income taxes for the year on $44,000. But please note: Your deduction may be reduced if you or your spouse have access to a retirement plan at work, depending on your income. (See the IRA deduction limits in the table in the article above.) Since the IRS gave you an upfront deduction, distributions in retirement will be taxed at your then income tax rate.

Contributions to a Roth IRA are made with after-tax dollars, so funding one won’t provide an immediate tax break. It’s when you start taking distributions in retirement that you’ll get tax relief: You won’t owe the IRS anything on qualified withdrawals.

Investment growth within both Roth and traditional IRAs is either tax-free or tax-deferred. With a Roth IRA, it’s tax-free, meaning you’ll never owe taxes on that money. With a traditional IRA, it’s tax-deferred, meaning you’ll owe taxes only when you start withdrawing the money in retirement.

In the short term, you have until the tax filing deadline in April to make contributions to a Roth or traditional IRA for the previous year.

Over the long term? Until recently, the rule was that you were unable to make contributions to a traditional IRA after age 70½, but the SECURE Act, which was signed into law in December 2019, removed that cap. Now there is no age limit on traditional IRA contributions (and there never was one on Roth IRA contributions).

Many discount brokers and robo-advisors have $0 minimums to open an IRA. You can see which ones in our roundup of best IRA providers. However, the tax perks of investing in an IRA start only when you start contributing money to the account. But don’t worry: You don’t need to come up with your full contribution all at once. You’re also not required to save the maximum the IRS allows (up to $6,000 in 2020, or $7,000 if you’re age 50 or over).

You can add money to your IRA at whatever cadence and amount work for your budget. Many brokers and robos allow savers to set up automatic deposits to transfer money from your bank into your account.

Below is a selection of information from primary sources consulted and reviewed by NerdWallet for this article:

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