What is an IRA? What does an IRA do?
An individual retirement account (IRA) is a type of tax-deferred or tax-free retirement savings account that many financial institutions offer.
In 2020, there are four main types of IRAs: Traditional, Roth, SEP and SIMPLE. But there are also these types: backdoor Roth, spousal, self-directed, inherited and rollover. They all have different advantages.
This guide will help you understand what you need to know to get started.
Understanding how an IRA works
What does an IRA do? In a nutshell, it lets you save money for retirement and get tax breaks for doing so.
Here are the general concepts to know.
An IRA is not the same thing as a 401(k). 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.
You can open an IRA at a bank or a broker. You set up an IRA account at a financial institution. If you get one from a broker, you’ll be able to invest in stocks and bonds; IRAs from banks generally offer Certificates of Deposit and savings accounts.
You invest the money in your IRA 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.)
Working people can add money to their IRA account every year. Generally, you (or your spouse) must have earned income to contribute to an IRA.
Contributions are limited. Two of the most popular types of accounts — the traditional and the Roth — allow you to add $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 2019 and 2020.
The withdrawal rules do let you withdraw your money any time, but you may face a 10% penalty and a tax bill if you do it 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.
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:
Tax advantages of IRAs
From a tax perspective, here are the main draws.
With a traditional IRA, 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.
With a 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.
» 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's a quick overview of the two most popular ones.
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.
There's no income cap. Anyone — regardless of income — can contribute to a traditional IRA account.
You may be able to deduct the contributions. That could mean a smaller tax bill. The amount 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 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.
Your 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 for 2019 and 2020, if you have a retirement plan at work
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.
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.)
You can't deduct the contributions. There's no tax deduction in the year you contribute to a Roth.
Your 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.)
You have some 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 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.
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 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
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.
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.
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.
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.
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.
Why invest in an IRA?
You're going to need income during retirement, and having money in an IRA account 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.
Below is a selection of information from primary sources consulted and reviewed by NerdWallet for this article: