What Is an IRA — and Do You Need One?

Investing, IRA
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An individual retirement account (IRA) is a type of savings vehicle that gives people tax breaks for investing money for the future.

The two main types of accounts are the traditional IRA and the Roth IRA. When and how you get your tax breaks depend on the type of IRA you choose.

Here are more details on each account type.

Traditional IRA

A traditional IRA offers an upfront tax break. Contributions may be deductible from your taxes for the year. That means that if you earn $50,000 and contribute $5,500 to an IRA, the amount of your taxable income falls to $44,500.

Another bonus: The investments in your IRA grow tax-deferred, meaning you owe nothing on the gains so long as the money remains in the IRA. Taxes don’t come due until you start withdrawing money in retirement, at which point you’ll pay income taxes on distributions at whatever your tax rate is at that time.

Anyone can contribute to a traditional IRA, regardless of income level. But the amount you’re allowed to deduct may be limited by how much you make and whether you or your spouse have access to a retirement plan at work. However, even a partial deduction is still a deduction.

A traditional IRA may be a good choice if … you think your current tax rate is higher than the tax rate you’ll face in retirement. That way you get the tax break when it benefits you the most.

» Read more about the many benefits of these accounts in our traditional IRA guide.

Roth IRA

The benefit of a Roth IRA is that it delivers a big tax break in the future. Unlike a traditional IRA, contributions are made with post-tax dollars, which means there’s no upfront tax deduction. So, if you earn $50,000 and contribute $5,500 to a Roth IRA, you still owe income taxes on the full $50,000. Like with a traditional IRA, investment gains within a Roth IRA grow tax-free. The big the payoff comes in retirement: Your withdrawals are not taxed at all. You’ll owe the IRS nothing because you already paid taxes when you made your contributions.

Eligibility to contribute to a Roth IRA is based on income, and only those below a certain threshold are permitted to fully fund an account. Still, partial contributions to a Roth IRA are allowed up to the point where they phase out completely.

A Roth IRA may be a good choice if … you’re in a lower tax bracket now than you’ll likely be in the future, or if you think individual tax rates are likely to rise.

» Learn more about how these accounts can build your savings in our Roth IRA Guide.

How to get started

With the basics under your belt, it’s time to figure out what type of IRA is best for you and where and how to open an account.

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.

Updated July 7, 2017.