What Is an IRA? Types of Individual Retirement Accounts

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An individual retirement account (IRA) is a tax-advantaged account that a person with earned income opens on their own, outside any employer plan, to save and invest for retirement. The tax code calls it an individual retirement arrangement, a broader legal term that also covers individual retirement annuities issued by insurance companies. The account itself is a wrapper: it holds stocks, bonds, funds, CDs or other assets, and its rules decide when the money is taxed, how much can go in each year and when it can come out without a penalty. The four main types are the traditional IRA, the Roth IRA, the SEP IRA and the SIMPLE IRA. They differ mainly in who can open them and whether the tax break comes now or later.

How an IRA works

Who can contribute

Anyone with earned income can contribute to an IRA, including people who also have a 401(k) or another plan at work. Earned income means pay for work: wages, salaries, tips, commissions, bonuses and net earnings from self-employment. Investment income and benefits do not qualify. A contribution also cannot exceed your taxable compensation for the year. Someone who earned $3,000 from a part-time job can contribute at most $3,000, even if the annual limit is higher.

There is one major exception to the earned-income requirement. A spousal IRA lets a married couple filing jointly fund an IRA for a spouse who has little or no income, based on the working spouse’s earnings.

Since the SECURE Act, there is no maximum age for contributing to a traditional IRA. Before 2020, contributions had to stop at age 70½. Roth IRAs never had an age cap.

Contribution limits and deadlines

The IRS sets a single annual contribution limit that applies to all of a person’s traditional and Roth IRAs combined. Opening a second or third IRA does not raise it. People age 50 and older can add a catch-up contribution above the base limit. The dollar amounts are adjusted periodically for inflation, so check the current figures on IRS.gov before contributing. SEP and SIMPLE IRAs have their own, separate limits.

Contributions for a given tax year can generally be made until that year’s tax filing deadline, which is usually mid-April of the following year. Contributing more than the limit creates an excess contribution. The excess is subject to a 6% excise tax for each year it stays in the account, unless you withdraw it in time.

Where an IRA is held and what it can own

An IRA must be held by an institution approved to act as custodian or trustee: banks, brokerages, mutual fund companies, federally insured credit unions and savings and loan associations. The custodian keeps the account and handles IRS reporting. You choose the investments.

What you can buy depends on the provider. A bank IRA may only offer savings accounts and CDs. A brokerage IRA typically offers stocks, bonds, exchange-traded funds and mutual funds. A self-directed IRA (SDIRA) uses a specialized custodian that allows alternative assets such as real estate, private companies or precious metals that meet IRS standards. Even so, the tax code prohibits some holdings. These include life insurance and most collectibles, such as art, antiques, gems, stamps and most coins.

IRAs are also subject to prohibited transaction rules. You cannot use the account for your own benefit before retirement. That means you cannot borrow from it, use it as collateral for a loan, sell your own property to it, or let the IRA buy a house that you or a close family member lives in. A prohibited transaction can cause the entire IRA to be treated as distributed, which makes the balance taxable at once.

The tax mechanism

Every IRA type shelters investment growth from annual taxation. Inside the account, dividends, interest and capital gains are not taxed in the year they occur, so the full amount stays invested and keeps compounding. Traditional, SEP and SIMPLE IRAs are tax-deferred: contributions are often deductible or pre-tax, and withdrawals are taxed as ordinary income. Roth IRAs take after-tax contributions, and qualified withdrawals, including all the growth, are tax-free.

Types of IRAs

Traditional IRA

A traditional IRA is the original version. Contributions may be tax-deductible. For a hypothetical saver who puts $4,000 into a traditional IRA and qualifies for a full deduction, taxable income for the year falls by $4,000. The money then grows tax-deferred, and withdrawals in retirement are taxed at the owner’s ordinary income tax rate for that year.

Whether the deduction is full, partial or zero depends on workplace plan coverage and income:

• Neither you nor your spouse is covered by a workplace plan: contributions are fully deductible, regardless of income.
• You are covered by a plan such as a 401(k) or 403(b): the deduction phases out across a range of modified adjusted gross income (MAGI). The range is lower for single and head-of-household filers and higher for married couples filing jointly.
• You are not covered but your spouse is: a separate, higher phase-out range applies to your deduction when you file jointly.

The IRS updates these ranges every year. If your income is too high for a deduction, you can still make a nondeductible contribution. The growth remains tax-deferred, and you track your after-tax basis on Form 8606 so that portion is not taxed again when you withdraw it.

Roth IRA

A Roth IRA reverses the timing. Contributions are not deductible, but qualified distributions are tax-free, including decades of investment gains. A distribution is qualified when the account has been open for at least five years (counted from January 1 of the year of the first Roth contribution) and the owner is 59½ or older, disabled, or deceased. The first-time home purchase rule also counts, up to a $10,000 lifetime limit.

Roth IRAs have two features the traditional IRA lacks:

1. No lifetime required minimum distributions. The owner never has to withdraw, so the money can keep growing tax-free.
2. Access to contributions. Withdrawals come out in a set order: contributions first, then conversions, then earnings. Your own contributions can be taken out at any time without tax or penalty. Earnings withdrawn early may be taxed and penalized.

The trade-off is an income ceiling. Roth eligibility phases out across a MAGI range set each year by the IRS. Above the range you cannot contribute directly. Some high earners make a nondeductible traditional IRA contribution and then convert it to a Roth, a strategy known as a backdoor Roth IRA. Conversions in general are allowed at any income level, but the converted pre-tax amount is taxable in the year of conversion.

SEP IRA

A Simplified Employee Pension (SEP) IRA is set up by an employer, including a self-employed person who is their own employer. Freelancers, independent contractors and small-business owners use it because it is easy to administer and allows larger contributions than a regular IRA.

Only the employer contributes. Employees cannot add their own salary deferrals. Contributions are capped at the lesser of 25% of each employee’s compensation or an annual dollar limit set by the IRS. Self-employed people calculate their own contribution using a special formula based on net self-employment earnings, which in practice works out lower than a flat 25%. If the owner contributes for themselves, they generally must contribute the same percentage of pay for every eligible employee. The business deducts the contributions, and withdrawals follow traditional IRA rules: taxed as ordinary income, with the same early-withdrawal and RMD rules.

SIMPLE IRA

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small businesses, generally those with 100 or fewer employees, that do not maintain another retirement plan. Unlike a SEP, it lets employees contribute through salary deferrals. The employer must also contribute, either by matching employee deferrals up to a set percentage or by making a fixed contribution for all eligible employees.

Employee deferrals have their own annual limit, which is lower than a 401(k) limit but higher than a regular IRA limit, plus a catch-up amount at age 50 and older. Contributions reduce taxable income, and withdrawals are taxed like a traditional IRA. One rule is stricter: withdrawals within the first two years of participation that do not qualify for an exception face a 25% additional tax instead of 10%.

Other IRA labels

Several other terms describe the same account types in a particular situation:

• Rollover IRA: a traditional IRA that receives money moved from an employer plan such as a 401(k).
• Inherited IRA: an account held by a beneficiary after the original owner dies. Under the SECURE Act, most non-spouse beneficiaries must empty it within 10 years. Spouses have more options, including treating the account as their own.

Comparing IRA types

SEP and SIMPLE IRAs can also accept Roth contributions under SECURE 2.0. That option depends on the employer and the custodian offering it.

Worked example: traditional vs. Roth

The choice between traditional and Roth comes down to one question: is your tax rate higher now or in retirement? This hypothetical example isolates that variable.

Assumptions: a saver sets aside $5,000 of pre-tax earnings, has a 22% marginal tax rate today, and the investment grows to four times its starting value by retirement. The growth rate is the same in both accounts.

Traditional IRA: the full $5,000 goes in because the contribution is deductible. It grows to $20,000. At withdrawal, tax at 22% is $4,400, leaving $15,600.

Roth IRA: the saver pays 22% tax first, which leaves $3,900 to contribute. It grows to $15,600, and the qualified withdrawal is tax-free: $15,600.

When the tax rate is the same at both ends, the two accounts produce identical after-tax results. The difference appears when rates change:

• If the retirement tax rate is 12%, the traditional IRA nets $17,600, beating the Roth.
• If the retirement tax rate is 32%, the traditional IRA nets $13,600, and the Roth wins.

Real-world factors also matter. Roth IRAs have no RMDs, so they offer more control over taxable income later. Traditional IRA withdrawals can raise the taxable share of Social Security benefits and affect Medicare premiums. Contributing the full Roth limit shelters more money in total, because each Roth dollar is already after tax. Many savers hold both types to keep their options open on future tax rates.

Withdrawals and the early-withdrawal penalty

The standard age for penalty-free withdrawals is 59½. Before that, a distribution from a traditional IRA (or the earnings portion of a Roth) is generally taxed as income and also hit with a 10% additional tax. A hypothetical $10,000 early withdrawal in a 22% bracket would cost $2,200 in income tax plus $1,000 in penalty, leaving $6,800.

The tax code waives the 10% additional tax, but not necessarily the income tax, in several situations, including:

1. Up to $10,000 (lifetime) used toward a first-time home purchase.
2. Qualified higher-education expenses for you, your spouse, children or grandchildren.
3. Unreimbursed medical expenses above a share of adjusted gross income.
4. Health insurance premiums paid while unemployed.
5. Total and permanent disability, or distributions to beneficiaries after death.
6. A series of substantially equal periodic payments (SEPP) under section 72(t), calculated over life expectancy.
7. Up to $5,000 per child for a qualified birth or adoption.
8. An IRS levy on the account.

The SEPP route is popular with early retirees in the FIRE movement. The payments must continue for at least five years or until age 59½, whichever is longer. Changing the schedule early brings back the penalty on past distributions, with interest.

Required minimum distributions

Required minimum distributions (RMDs) force money out of tax-deferred accounts so it is eventually taxed. They apply to traditional, SEP and SIMPLE IRAs, as well as 401(k)-type plans. Congress has raised the starting age twice. It was 70½ for decades, became 72 under the SECURE Act and rose to 73 under SECURE 2.0 for people reaching that age after December 31, 2022. It is scheduled to rise to 75 in 2033.

Calculation: RMD = account balance on December 31 of the prior year ÷ life expectancy factor from the IRS tables (usually the Uniform Lifetime Table).

As a hypothetical, a $500,000 balance divided by a factor of 26.5 gives an RMD of about $18,868 for the year. The factor shrinks as the owner ages, so the required percentage rises over time. Owners with several traditional IRAs calculate each account’s RMD separately but can take the combined total from any one or more of them.

The first RMD can be delayed until April 1 of the year after you turn 73. Doing that means two RMDs in the same tax year, which can push income into a higher bracket. Missing an RMD triggers an excise tax of 25% of the amount that should have been withdrawn. The rate drops to 10% if the shortfall is corrected within the allowed correction window.

Moving money into and between IRAs

Money can enter an IRA in three ways besides annual contributions:

• Direct rollover: an employer plan sends funds straight to an IRA custodian, with no tax withheld. Plan money moved directly is not subject to the annual contribution limit.
• Trustee-to-trustee transfer: one IRA custodian moves the account to another. There is no limit on how often you can do this.
• Indirect (60-day) rollover: you receive the money and redeposit it within 60 days. Only one IRA-to-IRA indirect rollover is allowed in any 12-month period. For distributions from an employer plan, 20% is withheld for taxes, and you must replace that amount from other funds to roll over the full balance.

Limitations of an IRA

Low contribution limits. The annual IRA limit is a fraction of what a 401(k) allows. An IRA alone may not be enough for someone who wants to save a large share of their income.

Restricted access. The 10% additional tax, the Roth five-year rule and the ban on loans make an IRA a poor place for an emergency fund.

The wash-sale rule still applies. Under Revenue Ruling 2008-5, if you sell a security at a loss in a taxable account and buy substantially identical shares in your IRA within 30 days, you cannot claim the loss. The IRA’s basis also does not increase, so the loss is permanently gone rather than deferred.

Insurance coverage depends on the asset. FDIC insurance covers deposits such as savings accounts and CDs held in an IRA at an insured bank, up to $250,000 per depositor for certain retirement accounts combined at the same bank. Stocks, bonds, funds and other brokerage IRA investments are not FDIC-insured and can lose value. SIPC protection covers a brokerage’s failure, not market losses.

No investment guarantee. The tax treatment improves after-tax returns, but the outcome depends on what you hold. A traditional IRA invested in cash may barely keep pace with inflation, while one invested in stocks will rise and fall with the market.

Beneficiary rules matter. An IRA passes through its beneficiary designation, not your will. An outdated form can send the account to the wrong person. Naming a trust as beneficiary is possible but adds distribution complexity.

How an IRA differs from a 401(k)

Both are tax-advantaged retirement accounts, and both come in pre-tax and Roth versions. The differences are about control and capacity:

The accounts are not either/or. A common approach is to contribute enough to a 401(k) to collect any employer match, then fund an IRA for broader investment choice, then return to the 401(k) for additional savings.

FAQs

The Bottom Line

IRAs matter to anyone with earned income, including people who already save in a 401(k) at work. The choice between traditional and Roth comes down mainly to whether your tax rate will be higher now or in retirement, and many savers hold both. With low limits and restricted early access, an IRA works best as long-term savings alongside a 401(k) and is a poor place for an emergency fund.