An individual retirement account (IRA) is a type of savings vehicle that gives people tax breaks for investing money for retirement. Thanks to those tax incentives, more of the dollars you save end up in your pocket — now, and in the future.
To explain exactly how IRAs work, let’s start at the top.
What is an IRA?
Contrary to what many believe, an IRA is not an investment: It’s an investment account you set up at a brokerage firm or other financial institution. Individuals add money to the account over time and use it to to purchase investments (such as individual stocks, mutual funds and bonds) that are held in the account. Eventually the money in that account can be withdrawn to provide income to live off of in retirement.
» Ready to open an account? Go straight to our IRA account provider ratings.
There are plenty of other IRA perks in addition to offering a break on income taxes:
- In both traditional and Roth IRAs the investments in your IRA grow tax-deferred, meaning you owe nothing on the gains so long as the money remains in the IRA.
- IRAs allow individuals to contribute up to $5,500 per year; that’s on top of what you can sock away in a 401(k) or other employer-sponsored retirement plan.
- Investors 50 and older are allowed to save even more per year — an extra $1,000 a year as a catch-up contribution.
- Although you shouldn’t withdraw money from an IRA before retirement, the IRS does allow individuals to take out money before age 59 ½ to pay for certain expenses. (For specifics see traditional IRA early withdrawals and the rules for Roth IRA distributions.)
How to choose the right type of IRA
There are two main types of IRAs: The Roth IRA and the traditional IRA. The difference comes down to when and how you get that tax break mentioned earlier.
A traditional IRA offers an upfront tax break. The money you put in this type of IRA 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 for the year falls to $44,500.
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.
Unlike a traditional IRA, the money you put into a Roth IRA is not deductible: Contributions are made with post-tax dollars. The payoff of contributing to a Roth is that it delivers a big tax break in the future. In retirement your withdrawals are not taxed at all. You’ll owe the IRS nothing because, remember, you already paid taxes when you made your contributions.
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.
While the Roth and traditional (or regular) IRA get most of the glory, they’re not the only IRA game in town. Specialty IRAs for the self-employed (SEP IRA), nonworking spouses (Spousal IRA), small business owners (Simple IRA) are designed with benefits that address different saver needs.
» More on deciding between a Roth versus traditional: See this side-by-side IRA comparison.
How to open an IRA
Before you open and fund an IRA there are a few housekeeping issues:
1. See which kind of IRA you are eligible for
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.
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, a partial deduction is still a deduction.
» Check your IRA eligibility to see which type of account you qualify to open and how much you’re allowed to contribute and/or deduct.
2. Decide if you want help managing the account
If you want to manage investments yourself, an online broker is a good way to go. Look for a provider that has low account fees (no inactivity or maintenance fees), reasonable trading commissions, reliable customer service and a large selection of no-transaction-fee mutual funds and commission-free exchange-traded funds.
» Online brokers ranked highest for DIY investors are based on costs, account minimums, investment tools and advice. See our recommendations for IRA account providers to compare.
Savers seeking hands-on help managing their retirement investments should consider hiring a robo-advisor — an automated and affordable version of a personal financial advisor that selects low-cost and risk-appropriate mutual funds and ETFs based on your time horizon and risk tolerance and rebalances your portfolio when adjustments are necessary.
» Pick the right robo-advisor: Our list of best robo-advisors is based on management fees, account minimums and financial planning services (tax planning, access to human advisors).
3. Set up the account
The online signup process is pretty simple: Provide some general information (Social Security number, birthday, contact information, employment details). Then choose how you want to fund the account — via bank transfer, perhaps rolling over a 401(k) from a previous employer. Not ready to write a big check? Many brokers allow you to set up regular, small transfers, which make it relatively painless to build up your retirement account balance.
4. Start investing
If you’ve gone the DIY route and set up an IRA at a brokerage firm, your cash will be placed in a holding pen — a low-interest money market account — until you decide how to deploy it. (A robo-advisor will start investing your money right away.) With a discount broker your investment choices are virtually unlimited. That can be overwhelming, which is why we’ve come up with this step-by-step process for how to choose investments for your IRA.
All those IRA resources in one place
For those who dig getting into the details, we’ve gathered all the IRA background reading right here:
- Roth IRA vs. traditional IRA: What you need to know
- All about retirement savings accounts
- IRS rules: What type of IRA are you allowed to open
Setting up an IRA
Managing an IRA
- IRA vs 401(k): How to manage both
- How to pick investments within your IRA
- Plug your IRA into your bigger financial plan
Updated July 7, 2017.