# Individual Retirement Account (IRA): What It Is, 4 Types

> **Definition**
>
> An IRA is a tax-advantaged savings account designed to help individuals save for retirement and includes traditional, Roth, SEP, and SIMPLE plans.

## What Is an IRA? Definition and Purpose

An individual retirement account (IRA)—known as an individual retirement arrangement by the IRS—is a long-term, tax-advantaged savings account that individuals with earned income can use to save for the future.

The IRA is designed primarily for self-employed people who do not have access to workplace retirement accounts such as the 401(k), which is available only through employers. However, you can also have an IRA even if you already have a retirement plan at work.

You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.

### Key Takeaways

*   [Individual retirement accounts (IRAs)](https://www.investopedia.com/the-best-ira-brokers-8764115) are retirement savings accounts with tax advantages.
*   Types of IRAs include traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
*   Money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn.
*   Annual income limitations apply to both the deductibility of contributions made to traditional IRAs and contributions made to Roth IRAs.
*   [Required minimum distributions (RMDs)](https://www.investopedia.com/terms/r/requiredminimumdistribution.asp) from a traditional IRA must begin at age 73.

![An illustration of a piggy bank with the text explaining an Individual Retirement Account IRA definition](https://www.investopedia.com/thmb/CGrfBLwzJbz9WabJ9LL4SWZsaFE=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/IRA_V1_4194258-7cf65db353ac41c48202e216dfbd46ee.jpg)

*— Investopedia / Paige McLaughlin*

## How Does an IRA Work?

Anyone with [earned income](https://www.investopedia.com/terms/e/earnedincome.asp) can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the total that you can contribute to your retirement accounts in a single year.

The best IRA accounts will offer the ability to invest in a wide range of financial products, including [stocks](https://www.investopedia.com/terms/s/stock.asp), [bonds](https://www.investopedia.com/terms/b/bond.asp), [exchange-traded funds (ETFs)](https://www.investopedia.com/terms/e/etf.asp), and [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp).

There are also [self-directed IRAs (SDIRAs)](https://www.investopedia.com/terms/s/self-directed-ira.asp) that permit investors to make all the investing decisions. SDIRAs offer access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.

There are several kinds of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These types include:

*   [Traditional IRAs](https://www.investopedia.com/terms/t/traditionalira.asp)
*   [Roth IRAs](https://www.investopedia.com/terms/r/rothira.asp)
*   [Simplified Employee Pension (SEP) IRAs](https://www.investopedia.com/terms/s/sep.asp)
*   [Savings Incentive Match Plan for Employees (SIMPLE) IRAs](https://www.investopedia.com/terms/s/simple-ira.asp)

Individual taxpayers can establish traditional and Roth IRAs. Small business owners and self-employed individuals can set up SEP and SIMPLE IRAs.

An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerages, federally insured credit unions, and savings and loan associations.

Because IRAs are meant to be used to invest and [maximize the growth of funds](https://www.investopedia.com/articles/personal-finance/110615/best-strategies-maximize-your-ira.asp) for retirement savings, there is usually an [early withdrawal penalty of 10%](https://www.investopedia.com/ask/answers/082515/how-do-you-calculate-penalties-ira-or-roth-ira-early-withdrawal.asp) if you take money out before age 59½. That's in addition to taxes you'd pay on the withdrawn amount.

However, there are some [notable exceptions](https://www.investopedia.com/ask/answers/081314/can-i-take-money-out-my-individual-retirement-account-ira-while-working.asp) to the penalty rule—withdrawals for educational expenses and first-time home purchases, among others.

A Roth account is funded with post-tax money, so no further taxes are due when the money is withdrawn.

> **Important**
>
> You can only contribute to an IRA if you have earned income. Income from interest and dividends, Social Security benefits, or child support does not count.

## IRA Types: Traditional, Roth, SEP, and SIMPLE Compared

The following is a breakdown of the various types of IRAs and the rules regarding each one.

### Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. So, if you put $4,000 into an IRA, your taxable income for the year decreases by that amount.

In a traditional IRA, your money grows tax-deferred. When you [withdraw it after retiring](https://www.investopedia.com/articles/personal-finance/121115/how-ira-works-after-retirement.asp), it is taxed at your [ordinary income](https://www.investopedia.com/terms/o/ordinaryincome.asp) tax rate for that year.

### Contribution Limits

Contribution limits can change from year to year, so it’s smart to check the IRS website for the latest numbers before you make your contributions.

If you don’t have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a [401(k)](https://www.investopedia.com/terms/1/401kplan.asp) or [403(b)](https://www.investopedia.com/terms/1/403bplan.asp), your [modified adjusted gross income](https://www.investopedia.com/terms/m/magi.asp) (MAGI) determines whether and how much of your traditional IRA contributions can be deducted.

**If You Have a Retirement Plan at Work**

Your ability to deduct traditional IRA contributions depends on your income if you or your spouse are covered by a workplace plan like a 401(k) or 403(b). The higher your income, the more likely your deduction will be partially reduced or phased out. Because the IRS updates these income limits regularly, check IRS.gov each year to see how much you can deduct.  

> **Warning**
>
> It’s possible to have both a Roth IRA and a traditional IRA, or even multiple IRAs at different institutions. However, the IRS sets a combined annual contribution limit for all of your IRAs, and that limit is the same no matter how many accounts you have. The limit is slightly higher for people age 50 or older who qualify for the catch-up contribution.

The income limits are lower if you file as single or head of household and higher if you are married filing jointly, which means joint filers can typically earn more before their deduction begins to phase out.

**If You Don't Have a Plan at Work but Your Spouse Does**

If you contribute to a traditional IRA and aren’t covered by a workplace plan but your spouse is, your ability to deduct contributions generally depends on your household’s income and applies when you file jointly. The deduction begins to phase out once your income reaches a certain level. The IRS adjusts this amount each year; find the latest information on IRS.gov.  

### Roth IRA

Roth IRA contributions are not tax-deductible in the year in which you make them. But the distributions are tax-free. That means you contribute to a Roth IRA using after-tax dollars and pay no taxes, even on your investment gains.

Also, Roth IRAs do not have RMDs. If you don’t need the money, you don’t have to take it out of your account (where it continues growing tax-free). You can contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits in any given [tax year](https://www.investopedia.com/terms/t/taxyear.asp) are usually the same as they are for traditional IRAs. However, there is a catch: There are [income limitations](https://www.investopedia.com/ask/answers/082515/why-are-ira-roth-iras-and-401k-contributions-limited.asp) on contributions to a Roth IRA.

The phase-out range is the income window where your allowed Roth IRA contribution gradually decreases until you can no longer contribute. Since these ranges are updated each year, visit IRS.gov to confirm how much you can contribute based on your current income.

> **Fast Fact**
>
> Those who reach the RMD age after Dec. 31, 2022, must start taking RMDs beginning at age 73. This rule applies to traditional IRAs, 401(k)s, SEP IRAs, and SIMPLE IRAs. Roth IRA owners are not required to take RMDs during their lifetime. If you miss an RMD, the penalty is generally 25% of the amount that should have been withdrawn, but it can be reduced to 10% if you correct the mistake within the allowed time frame.

### SEP IRA

Self-employed individuals such as independent contractors, freelancers, and small-business owners can set up SEP IRAs.

A SEP IRA follows the same tax and withdrawal rules as a traditional IRA, but contributions work differently. They are capped at a percentage of your compensation, up to an annual limit set by the IRS. Because these limits are adjusted periodically, check IRS.gov for the current maximum before contributing.

Business owners who set up SEP IRAs for their employees can deduct the contributions they make on behalf of employees. However, the employees cannot contribute to their accounts, and the IRS taxes their withdrawals as income.

### SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. This type of IRA follows the same tax rules for withdrawals as a traditional IRA.

Unlike SEP IRAs, [SIMPLE IRAs allow employees to contribute](https://www.investopedia.com/ask/answers/102714/how-do-i-report-simple-ira-contributions-w2.asp) to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially lowering the business or employee's tax bracket.

Employee contributions are subject to annual limits set by the IRS, with an additional catch-up contribution allowed for those age 50 or older. Because these limits are adjusted periodically, check IRS.gov for the most current contribution amounts.

### Wash-Sale Rule and IRAs

In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can [trigger the wash-sale rule](https://www.investopedia.com/articles/retirement/09/ira-wash-sale-rule.asp). Should shares be sold in a non-retirement account, followed by the purchase of substantially identical shares in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment’s basis in the individual’s IRA won’t increase, either.

## Required Minimum Distributions (RMDs): When and How They Apply

Required minimum distributions (RMDs) are withdrawals that owners of traditional IRA and 401(k) accounts must take every year after they reach a certain age. The age has been revised upwards a couple of times. As of Jan. 1, 2023, an account holder must begin taking money out in the year they turn age 73. That age rises to 75 in 2033.

The amount a person must withdraw is based on the account size and the person's life expectancy. The IRS has a worksheet to calculate the amount.

Failure to take the minimum triggers a severe tax penalty, which is 25% of the balance of the account. That's half the previous penalty but still expensive enough to keep us on our toes.

However, this penalty can be reduced to 10% in many cases if the taxpayer takes corrective action early.

## Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

_Note: To view the full chart, use the slider at the bottom to see the column at the far right._

## What Does IRA Stand for?

The acronym "IRA" refers to two distinct but overlapping concepts. For the Internal Revenue Service, the term stands for "individual retirement arrangement," a selection of plans available that provide tax advantages to people saving for retirement.

In common usage, IRA also stands for "individual retirement account," a type of plan that one can pay into throughout one's career and withdraw from in retirement. In such cases, a plan would be both a retirement account for a specific person and an individual retirement arrangement in the eyes of the IRS.

## What Are the Advantages of an Individual Retirement Account (IRA)?

An IRA offers a tax-advantaged way to save for retirement. Depending on what type of IRA you use, it can reduce your tax bill when you make contributions or take withdrawals in retirement. Investment gains are tax-deferred (for a traditional IRA) or tax-free (for a Roth IRA).

That means contributing money towards your retirement either [reduces your taxes on income](https://www.investopedia.com/ask/answers/012715/what-are-best-ways-lower-my-taxable-income.asp) for the year or eliminates the taxes on your retirement money.

IRAs are insured by the [Federal Deposit Insurance Corp. (FDIC)](https://www.investopedia.com/terms/f/fdic.asp), a government-run agency that provides protection when a financial institution fails. The FDIC covers customer deposits—up to $250,000 per account in most cases—that are held at FDIC-insured banks or savings and loan associations.

## How Can I Start a Roth IRA or a Traditional IRA?

You can [open your IRA](https://www.investopedia.com/how-to-open-an-ira-7504812) at most banks, credit unions, online brokers, or other financial services providers. Fidelity, Charles Schwab, and E\*Trade are all brokers that provide IRAs.

Opening an account is as easy as visiting a bank branch or website and filling in a form.

## When Can I Withdraw From an IRA?

The best time to withdraw from an IRA is at age 59½ and beyond. If you withdraw before age 59½, you will incur a 10% early withdrawal penalty in addition to taxes on the withdrawal. There are some exceptions to this penalty for medical expenses, disabilities, first-time home purchases, and other unusual life events. Generally speaking, the longer you can wait before taking distributions, the [more time that money has to grow](https://www.investopedia.com/managing-wealth/grow-ira-100-million-plus/).

## How Is a 401(k) Plan Different From an IRA?

Both 401(k) plans and IRAs provide tax advantages to employees investing for their retirement. However, a 401(k) plan is only available through an employer. Contributions are automatically deducted from the employee’s paycheck. Some companies match part of employee contributions. Also, 401(k) plans have higher contribution limits.

An IRA can be set up by anyone who has earned income, regardless of whether they have a 401(k) plan at work. Most 401(k) plans offer a limited choice of mutual funds and exchange-traded funds (ETFs). An IRA can offer a wider range of funds, stocks, and other securities.

## The Bottom Line

IRAs are retirement savings accounts that offer tax advantages. They work a bit like a 401(k) but don’t require an employer to sponsor them. There are several types of IRAs: traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

There are annual income limitations on deducting contributions to traditional IRAs and contributing to Roth IRAs, so there is a limit on how much tax you can avoid by investing in an IRA.

IRAs are meant to be long-term retirement savings accounts. If you take money out early, you defeat that purpose by diminishing your retirement assets. That’s why money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn (in addition to normal taxes owed).

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>     
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