What Is an IRA?

Investing, IRA
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Quick facts about IRAs

  • An IRA is a type of tax-favored retirement savings account
  • You can set up an account at a bank or brokerage firm
  • Individuals can contribute up to $5,500 a year ($6,500 if age 50 or older) to an IRA
  • There are no contribution limits if you’re rolling over an old 401(k) into an IRA
  • Traditional IRA contributions may be tax-deductible; withdrawals in retirement are taxed as income
  • Roth IRA contributions are not deductible, but withdrawals in retirement are tax-free

An individual retirement account is a savings and investing account that makes it easy — and financially worthwhile — to save for retirement. The two main types of accounts are the Roth IRA and the traditional IRA.

Setting up an account is simple, and you can do it at a bank or brokerage firm. The payoff comes in the form of multiple tax breaks from the IRS, as well as knowing you’re doing something to provide for your future financial security.

For those who don’t have access to an employer-sponsored retirement plan, are self-employed or are a stay-at-home spouse, an IRA is an essential tool for saving for the future. And even if you’re covered by a workplace plan such as a 401(k), supplementing your savings with an IRA provides flexibility and a further savings boost.

Each letter of “IRA” reveals important details about how these tax-favored accounts work and why they’re such an important tool for saving for retirement:

Individual: Unlike retirement plans offered through an employer, such as a 401(k), pension or profit-sharing plan, an IRA is set up and funded by you. Individuals are allowed to contribute to both a workplace plan and an IRA. But if you have to choose or want to know which plan to max out first, see our IRA vs. 401(k) guidelines. And if you have money lingering in a former employer’s retirement plan, consider rolling over your 401(k) into an IRA to take back control of your savings.

Retirement: An IRA is like an assigned spot for your money in the IRS’ long-term-savings parking lot. Tax rules discourage savers from taking money out of the account for a joyride before retirement age. The “or else” implied at the end of that sentence refers to the consequences of breaking the rules: Withdraw money before age 59½, and you may be hit with a bill for income taxes plus a 10% early withdrawal penalty. (There are exceptions to the rules; read more on Roth IRA distribution rules and traditional IRA distribution rules.) In general, if you think you’ll need access to the money before retirement age, a Roth IRA offers more favorable terms and fewer penalties.

Account: When someone says “my IRA is up 5%,” what they really mean is “the investments in my IRA are up 5%.” An IRA is merely the vessel that holds the investments you choose among stocks, bonds, mutual funds and more. And there’s not just one type of IRA, either. (Technically, IRA stands for individual retirement “arrangement,” a term that encompasses all the different types of individual retirement accounts.)

The two main types are the traditional IRA and the Roth IRA. Others are designed specifically for the benefit of the self-employed (SEP IRA), stay-at-home spouses (spousal IRA) and small business owners (Simple IRA). See this IRA comparison table for pros, cons and details about all of these types of IRAs and more.

» Save on taxes today: Use NerdWallet’s free retirement planning tool to see which investing accounts give you the most tax benefits.

What’s in it for you: Tax breaks galore

If you’re looking for a way to shield your income from taxes — now, in the future or both — postpone or avoid paying taxes on investment gains, and generally set yourself up for a much brighter future, IRAs offer all that and more.

When and how you get your tax breaks depend on the type of IRA you choose. As we said, there are two main types of accounts. Here’s how they differ:

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.

Is a traditional IRA a good choice for you? Because a traditional IRA allows you to postpone taxes, it’s a good choice for those who think their current tax rate is higher than it will be in retirement. That way you get the tax break when it benefits you the most.

» Learn more: Traditional IRA contribution limits and deduction guidelines

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.

Is a Roth IRA a good choice for you? Because a Roth IRA offers tax savings in retirement, it’s a good account 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.

» Find out more:  Roth IRA rules

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 April 5, 2017.