What is an IRA?: Types of IRAs and how they work
January 19, 2023 7 min read
Saving up for retirement can help people make sure that when they stop working, they’ll have enough money to live comfortably.
One way to save for retirement is with an individual retirement account (IRA). Also known as an individual retirement arrangement, an IRA is a type of personal savings account. But not only does an IRA provide a place to stash savings for retirement income, it has tax benefits, too.
Read on to learn about different types of IRAs, how they work and how to get started saving.
- An IRA is a retirement account set up by individuals rather than through employers.
- The three main types of IRAs are traditional IRAs, Roth IRAs and rollover IRAs.
- Traditional IRAs are funded with pretax dollars, while Roth IRA contributions are made after taxes.
- A rollover IRA is an IRA funded with money from a former employer-sponsored 401(k) that doesn’t incur early withdrawal penalties.
What is an IRA?
An IRA is a savings account built to help people save for retirement. In general, anyone with earned income is eligible to open an IRA. Account holders may be able to establish an IRA with a number of financial institutions, including banks, credit unions, online brokerage companies and insurance agencies.
IRAs are funded by deposits—or contributions—from the primary account holder. IRA contribution amounts are limited by the Internal Revenue Service (IRS) depending on the account holder’s age, income and the type of IRA.
Types of IRAs
There are three main types of IRAs:
- Traditional IRA
- Roth IRA
- Rollover IRA
But there are other kinds of IRAs, too, including simplified employee pension (SEP) IRAs and savings incentive match plan for employees (SIMPLE) IRAs.
Traditional and Roth IRAs can be opened by individuals. SEP IRAs and SIMPLE IRAs are usually opened by self-employed individuals and small-business owners. The rules and annual contribution limits for SEP IRAs and SIMPLE IRAS are different from traditional and Roth IRAs.
Consider the following to better understand the differences between the three main types of IRAs:
Traditional IRAs are retirement accounts that have certain tax benefits for account holders. Traditional IRA contributions are usually made with pretax dollars that can be tax deductible in some cases. But deductions may depend on income and tax filing status.
Generally, traditional IRA account holders pay income tax on withdrawals (including any account growth) when they reach retirement age at age 59½. If withdrawals are made before that age, there may be a 10% penalty as well.
Like traditional IRAs, Roth IRAs are tax-advantaged retirement accounts. But Roth IRA contributions are made with after-tax dollars. Those contributions aren’t usually tax deductible either. Roth IRAs may have additional eligibility requirements, such as income and tax filing status.
Roth IRA distributions—including any account growth—claimed after age 59½ are typically both tax free and penalty free.
A rollover IRA is an IRA that’s been rolled over from another retirement account, usually a former employer-sponsored 401(k). The funds in the old retirement account are transferred to an IRA, often after a worker changes jobs and no longer participates in the old employer’s 401(k) plan.
If the funds are transferred from a traditional 401(k) to a traditional IRA, account holders usually won’t have to pay penalties or taxes. But if the rollover is from a traditional IRA or 401(k) to a Roth IRA, the funds may be subject to taxes.
Key differences between traditional and Roth IRAs
Here’s an at-a-glance breakdown of the differences between traditional and Roth IRAs:
|Tax status of contributions
|Are withdrawals taxed?
|Are earnings taxed?
|Only if withdrawn before age 59 1/2
|Income limits to contribute?
|Yes, starting at age 70 1/2
|Are contributions tax deductible?
|Maybe, depending on income
|Early withdrawal penalties
|10% on both contributions and earnings
|10% on earnings
Benefits of an IRA
Aside from having a place to save money for retirement, the main benefits of an IRA are the tax advantages.
Depending on the type of IRA, contributions can be made from pretax income (known as tax-deferred contributions) or after taxes have already been taken out. Tax-deferred contributions are taxed after retirement, when the account holder begins making withdrawals. But post-tax contributions are taxed upfront, which means future distributions may be tax free.
How is an IRA different from a 401(k)?
IRAs and 401(k) plans are both vehicles for retirement savings, and people with a 401(k) plan may choose to open an IRA as well. But an IRA is an individual retirement account set up by the account holder, while a 401(k) is a retirement account from an employer.
There are other key differences between a 401(k) and an IRA, including:
- Who opens the account: A 401(k) plan—also known as a defined contribution plan—is offered by employers to their employees, while an IRA is typically opened by an individual.
- Who contributes to the account: The account holder typically makes contributions to both an IRA and a 401(k). But many employers will make matching 401(k) contributions up to a certain percentage of an employee’s income. Since IRAs are generally set up by individuals, there’s usually no employer match.
- How much can be contributed annually: For 2022, the contribution limit for a 401(k) was $20,500. For 2023, the limit is $22,500. For people aged 50 and over, the IRS allows an additional catch-up contribution of $6,500 in 2022 and $7,500 in 2023. IRA contribution limits for both traditional and Roth account types were $6,000 in 2022 ($7,000 if over 50 years old) and $6,500 in 2023 ($7,500 if over 50 years old).
How to open an IRA
Here are the steps to set up an IRA:
1. Choose a financial institution
IRAs are available at various financial institutions, including banks and investment firms. Before selecting a financial institution, investors may want to consider the range of investment options available, what fees the account holder can expect to pay and how they’d prefer to manage the account, such as with a robo-adviser, an account manager or self-directed investing.
2. Pick the type of IRA to open
Deciding whether to open a traditional or Roth IRA may depend on income, estimated retirement age and anticipated tax rate in retirement. A tax adviser may be able to provide input into which type would be most beneficial.
3. Establish the account
Opening an IRA is usually easy and can often be done online. Documents and personal information may be required, such as a Social Security number, government identification, date of birth and address.
The account holder will usually need to specify how the contributions will be made and provide relevant banking information as well.
4. Make contributions and choose investments
IRA contributions can usually be made with a check, bank transfer or through direct deposit. Just remember to keep tabs on contributions to avoid exceeding the annual limits.
And before choosing investments in an IRA, start by considering financial goals and retirement timelines. It’s usually a good idea to weigh risk tolerance, or how much volatility is acceptable, too. Enlisting a professional financial planner may help when choosing investment portfolios.
IRAs in a nutshell
Saving money for retirement in an IRA can help workers enjoy a secure financial future while also taking advantage of tax benefits. And for those who already have 401(k) plans through their employers, opening an IRA can serve as an additional place to save even more money for retirement.
Thinking of leaving the workforce altogether? Here’s what to know about how to retire early.