An IRA is a savings account the government lets you use tax-free or tax-deferred to build retirement money

An Individual Retirement Account (IRA) is a bank or investment account you open in your own name to save for retirement. The government gives you tax breaks on the money you put in or the money it earns, depending on which type of IRA you choose. You control what happens to the money inside it — you decide how much to put in each year (up to a limit set by law), and you decide how to invest it. The catch is that you generally cannot take the money out before age 59½ without paying a penalty, though some exceptions exist.

The main reason to use an IRA instead of a regular savings account is the tax benefit. With a regular account, you pay income tax on any interest or investment gains every year. With an IRA, that tax is either delayed (in a Traditional IRA) or never charged at all (in a Roth IRA). Over decades, that difference adds up to thousands of dollars more in your retirement account.

Key Takeaways

  • An IRA is a retirement savings account you open yourself, not through an employer, and the government gives you tax breaks on the money inside it.
  • A Traditional IRA lets you deduct contributions from your taxes now, but you pay income tax when you withdraw the money in retirement.
  • A Roth IRA takes money after you have already paid taxes on it, but the money grows tax-free and you owe no tax when you withdraw it later.
  • You can contribute up to a set annual limit (the limit changes each year), and you cannot withdraw without penalty before age 59½ in most cases.
  • You can open an IRA at a bank, credit union, brokerage, or investment company, and you control how the money is invested.

Traditional IRA vs. Roth IRA: the two main types

The two most common IRAs work in opposite directions. With a Traditional IRA, you put in pre-tax money (or money you deduct from your taxes that year), it grows without being taxed, and then you pay income tax on whatever you withdraw after age 59½. With a Roth IRA, you put in money you have already paid taxes on, it grows without being taxed, and you owe zero tax when you withdraw it in retirement.

Which one makes sense depends on whether you think your tax rate will be higher now or in retirement. If you are in a high tax bracket now and expect to be in a lower one later, a Traditional IRA saves you more money today. If you are in a lower tax bracket now and expect to earn more later, a Roth IRA locks in today's lower tax rate on all your future gains. If you are unsure, many people split the difference and contribute to both.

There are income limits for Roth IRAs — if you earn above a certain amount, you cannot contribute the full amount or cannot contribute at all. Traditional IRAs have no income limit, but if you or your spouse have a workplace retirement plan, the tax deduction phases out at higher incomes. The income limits change each year.

How much you can contribute each year

The law sets an annual limit on how much you can put into an IRA. That limit is the same whether you have a Traditional IRA, a Roth IRA, or both — the total across all your IRAs cannot exceed the yearly cap. The limit changes most years to keep up with inflation, so you need to check the current year's limit before you contribute.

If you are age 50 or older, you can contribute an extra amount called a catch-up contribution. This is designed to let people who started saving late put in more money in their final working years. The catch-up amount is separate from the main limit and also changes each year.

If you contribute more than the limit in a single year, you will owe a penalty tax on the excess. If you find out you over-contributed, you can withdraw the extra money and the earnings on it by the tax filing deadline (usually April 15 of the following year) to avoid the penalty, though you will still owe tax on the earnings.

When you can withdraw money and what happens if you do it early

The general rule is that you cannot withdraw money from an IRA before age 59½ without owing a 10 percent penalty on top of income tax. That penalty is on top of the regular income tax you owe on the withdrawal, so taking money out early is expensive. However, the law carves out specific situations where you can withdraw without the penalty.

Common exceptions to the early withdrawal penalty include a first-time home purchase (up to $10,000 lifetime), medical expenses that exceed a certain percentage of your income, disability, medical insurance premiums while unemployed, and substantially equal periodic payments (a complex rule that requires you to take the same amount every year). Roth IRAs have an additional exception: you can always withdraw the money you contributed (not the earnings) without penalty, because you already paid taxes on it.

Even if you may have access to for an exception to the penalty, you still owe income tax on the withdrawal unless it is a Roth IRA withdrawal of your contributions. The penalty and the tax are separate costs, so do not assume an exception means the withdrawal is free.

Where to open an IRA and what to invest in

You can open an IRA at almost any financial institution: a bank, credit union, brokerage firm, investment company, or even some insurance companies. Each place offers different investment options inside the account. A bank IRA might let you choose between savings accounts and CDs. A brokerage IRA might let you buy individual stocks, mutual funds, exchange-traded funds (ETFs), or bonds. An investment company IRA typically offers their own mutual funds.

The institution does not decide how your money is invested — you do. You can be as hands-off as you want (putting everything in a target-date fund that automatically adjusts as you age) or as active as you want (picking individual stocks). You can also change your investments whenever you want without penalty, as long as you stay within the account.

Shop around before you open an account. Different institutions charge different fees, offer different investment options, and have different minimum balances. Some charge annual account fees, some charge per transaction, and some charge nothing. Over decades, low fees make a real difference in how much money you end up with.

Required minimum distributions and what happens at age 72

Once you reach age 72, the government requires you to start taking money out of your Traditional IRA each year, whether you need it or not. This is called a required minimum distribution (RMD). The amount is calculated based on your age and the balance in your account at the end of the previous year. If you do not take out the required amount, you owe a penalty on the shortfall.

Roth IRAs do not have required minimum distributions while you are alive — you can leave the money in the account to grow as long as you want. However, if you inherit a Roth IRA from someone else, different rules apply, and you may be required to withdraw money within a certain timeframe.

If you are still working and do not need the money, you can still take the distribution and reinvest it elsewhere. The requirement is just that you withdraw it from the IRA, not that you spend it.

How an IRA fits with workplace retirement plans

An IRA is separate from any retirement plan your employer offers, like a 401(k) or 403(b). You can have both at the same time. Some people use an IRA as their only retirement savings if they are self-employed or their employer does not offer a plan. Others use an IRA to save extra money on top of what they contribute to a workplace plan.

If you leave a job, you can roll over the money from your employer's retirement plan into an IRA. This is called an IRA rollover. Rolling over keeps the money in a tax-deferred account and gives you more control over how it is invested. You have 60 days to complete the rollover, or the money becomes taxable income.

Some people also use an IRA to convert money from a Traditional IRA to a Roth IRA, a process called a Roth conversion. When you convert, you pay income tax on the amount you convert, but then that money grows tax-free in the Roth. This strategy makes sense if you expect your tax rate to be higher in retirement or if you want to leave tax-assistance programs to heirs.

Frequently Asked Questions

Can I have more than one IRA?

Yes, you can have multiple IRAs at different institutions. However, the annual contribution limit applies to all your IRAs combined, not to each account separately. If you have a Traditional IRA and a Roth IRA, your total contributions across both cannot exceed the yearly limit.

What happens to my IRA if I die?

Your IRA passes to whoever you named as the beneficiary on the account. They do not pay inheritance tax on it, but they do owe income tax on withdrawals (unless it is a Roth IRA). The rules for how quickly they must withdraw the money depend on their relationship to you and when you died.

Can I borrow money from my IRA?

You cannot borrow from a Traditional IRA at all. With a Roth IRA, you can withdraw your contributions (the money you put in) anytime without penalty, which is effectively borrowing from yourself. However, you cannot take out a loan against the account the way you can with some workplace retirement plans.

What if I do not have earned income — can I still open an IRA?

You must have earned income (wages, self-employment income, or similar) to contribute to an IRA. However, a spouse with no income can open a spousal IRA if the other spouse has earned income, and they can contribute up to the annual limit based on the working spouse's income.

Is there a penalty if I close my IRA?

Closing an IRA itself is not penalized, but withdrawing the money is subject to the same rules as any other withdrawal. If you are under 59½ and do not may have access to for an exception, you will owe the 10 percent penalty plus income tax on the amount you withdraw.