What is an IRA account, and how does it work? (2024)

Personal Finance Retirement

Written by Aly J. Yale; edited by Jasmine Suarez

What is an IRA account, and how does it work? (1)

  • What is an IRA?
  • Types of IRAs
  • IRA contribution limits: 2023
  • IRA contribution limits: 2024
  • How are IRA distributions taxed?
  • Pros and cons of IRAs
  • IRA vs. 401(k)
  • FAQs
  • Bottom line
What is an IRA account, and how does it work? (2) What is an IRA account, and how does it work? (3)

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  • An Individual Retirement Arrangement (IRA) is a type of retirement account for individuals that provides various tax advantages.
  • Depending on which type of IRA you have, you contribute either pre- or post-tax dollars and invest the funds.
  • IRAs come with more investment flexibility than 401(k)s, which are employer-sponsored plans.

An Individual Retirement Arrangement, or IRA, is a type of retirement account for individuals you can use to both save and invest for retirement.

Many people use IRAs to augment other retirement accounts and to leverage their many tax benefits. Depending on the type of IRA you choose, which will be covered later, contributions may be tax-deductible or you may enjoy tax-free withdrawals in retirement.

"IRAs are simple and are an extremely easy investment plan to help save for your retirement years," says Wilson Coffman, president at Coffman Retirement Group.

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What is an IRA?

With an IRA, you'll contribute money to the account as desired throughout the year. You can then use the funds to invest in various assets, including mutual funds, index funds, stocks, bonds, ETFs, and other investments. As those assets increase in value, your IRA's value rises as well.

To open an IRA, you'll go through a brokerage or local bank. "IRAs are extremely easy to establish and set up," Coffman says. "Most banks offer an IRA and any brokerage outfit will offer IRA accounts. There are also many investment firms, like Fidelity, that can offer investment platforms for online retirement savings accounts as well."

Once set up, you'll then fund the account using bank payments, checks, or, if you have other retirement accounts, an IRA rollover.

Types of IRAs

There are several types of IRAs, each with their own unique contribution limits, taxation structure, and use cases.

The main four include:

  • Traditional IRA: This type of IRA is funded with pre-tax earnings. Contributions are tax-deductible, and you'll pay taxes on the funds when you withdraw them in retirement. They're typically best if you expect your tax bracket to be lower in retirement.
  • Roth IRA: With Roth IRAs, you fund the account with after-tax earnings. This allows the money to grow tax-free, and you'll pay no additional taxes upon withdrawal. They're a good option if you know your tax bracket will be higher in retirement.
  • SEP IRA: SEP IRAs are for self-employed professionals or small businesses. They have much higher contributions than traditional and Roth IRAs and are taxed upon withdrawal.
  • SIMPLE IRA: SIMPLE IRAs are another type of small business retirement account. These are also funded with pre-tax dollars and taxed once you withdraw money.

Most people find themselves choosing between traditional and Roth IRAs. According to Clark Howard, author and host of The Clark Howard Podcast, future taxes should play a big role in deciding between the two.

"The biggest difference between a traditional IRA and a Roth IRA is the treatment of taxes," Howard says. "ln general, tax rates are likely to go up over the years no matter which political party is in power. That means it may make more sense to skip the tax deduction you get up front with a traditional IRA to avoid tax later by investing with a Roth IRA."

IRA contribution limits for 2023

The IRS has set contribution limits on IRAs, but the exact amount depends on your age, your taxable compensation for the year, and the type of IRA you've established.

Here's how IRA contributions break down for 2023:

IRA typeContribution limit
Traditional and Roth IRAs< 50 years of age: $6,500 or your taxable income for the year (whichever is less)
50 or older: $7,500 or your taxable income for the year (whichever is less)
SIMPLE IRAs< 50 years of age: $15,500
50 or older: $19,000
SEP IRAs$66,000 or 25% of your compensation, whichever is less

With Roth IRAs, you may not be able to contribute up to the full maximum. Here's how your modified AGI and tax filing status can impact your contribution limits on these accounts in 2023:

Filing statusModified AGIYou can contribute ...
Married filing jointly or qualifying widow(er)Less than $218,000Up to the limit
$218,000 or more but less than $228,000A reduced amount
More than $228,000Zero
Married filing separately and you lived with your spouse at any time during the yearLess than $10,000A reduced amount
$10,000 or moreZero
Single, head of household, or married filing separately and you did not live with your spouse at any time during the yearLess than $138,000Up to the limit
$138,000 or more but less than $153,000A reduced amount
$153,000 or moreZero

IRA contribution limits for 2024

The IRS has increased limits for 2024. Here's how IRA contributions break down for 2024:

IRA typeContribution limit
Traditional and Roth IRAs< 50 years of age: $7,000 or your taxable income for the year (whichever is less)
50 or older: $8,000 or your taxable income for the year (whichever is less)
SIMPLE IRAs< 50 years of age: $16,000
50 or older: $19,500
SEP IRAs$68,000 or 25% of your compensation, whichever is less

And these are the income limits for Roth IRA contributions in 2024:

Filing statusModified AGIYou can contribute ...
Married filing jointly or qualifying widow(er)Less than $230,000Up to the limit
$230,000 or more but less than $240,000A reduced amount
More than $240,000Zero
Married filing separately and you lived with your spouse at any time during the yearLess than $10,000A reduced amount
$10,000 or moreZero
Single, head of household, or married filing separately and you did not live with your spouse at any time during the yearLess than $146,000Up to the limit
$146,000 or more but less than $161,000A reduced amount
$161,000 or moreZero

How are IRA distributions taxed?

The tax treatment of an IRA depends on the type of account. With traditional, SIMPLE, and SEP IRAs, contributions are tax-deductible, and you fund the account with pre-tax dollars, meaning you won't pay taxes until you withdraw money later on.

With Roth IRAs, you contribute post-tax dollars — or money you've already paid income taxes on. This allows for tax-free withdrawals in retirement.

"IRAs are either taxed at the beginning or the end," says Christy Matzen, previously director of financial planning at Zoe Financial. "When you make a contribution, you can pay tax on the dollars before you put it into the account — this will let you take the money out tax-free, or you can take a tax deduction when you make the contribution, but then the money will be taxed when you take it out."

Pros and cons of IRAs

IRAs can be a good way to save for retirement, but they're not perfect. As with anything, they come with both pros and cons.

On the one hand, they come with many tax benefits and can allow you to invest your funds in a variety of assets. On the other, there are age limits on when you can withdraw funds (or face a penalty), and in many cases, the contribution maximums may be lower than on other types of retirement accounts. For example, 401(k)s allow you to contribute up to $20,500 annually.

ProsCons
  • Many tax benefits, including tax deductions and tax-deferred growth

  • Allow you to invest in a variety of assets

  • Several types to choose from

  • Lower contribution limits than some other retirement accounts
  • Early withdrawal penalty of 10%
  • No employer contributions, like with 401(k)s

IRA vs. 401(k)

401(k)s are another popular type of retirement account, but they're quite different from IRAs. Here's a quick look at their main differences:

IRA401(k)
  • Individual plan

  • Funded with either pre-tax or post-tax dollars

  • Contribution limit of $6,500 per year ($7,500 for those 50 or older) in 2023; $7,000 per year ($8,000 for those 50 or older) in 2024

  • Can pick and choose your investments

  • No employer contributions

  • Employer-sponsored plan
  • Funded with pre-tax dollars
  • Contribution limit of $22,500 per year ($30,000 for those 50 or older) in 2023; $23,000 per year ($30,500) in 2024
  • Allow for 401(k) loans if you need money before retirement
  • Limited to the investment options your employer has chosen
  • May come with employer contributions

IRA FAQs

What is an IRA, and how does it work?

IRA stands for Individual Retirement Arrangement, and it's a type of retirement account you open on your own, not through an employer. You deposit money into the IRA, then invest the money in things like stocks or index funds.

Is a 401(k) the same as an IRA?

No, a 401(k) is a retirement savings account offered through an employer, and an IRA is a retirement account you open on your own.

Is it better to have a 401(k) or IRA?

A 401(k) is often better because most employers match a percentage of your contributions. However, an IRA typically has more investment options. Each has its own tax advantages, so the best choice could come down to your situation — and you can open both if you want to.

What are the three types of IRAs?

The three main types of IRAs are traditional, Roth, and rollover IRAs. With traditional IRAs, you contribute pre-tax dollars. You contribute after-tax dollars into a Roth IRA. A rollover IRA is funded by money you roll over from a retirement account you had with a previous employer.

Should you open an IRA?

An IRA is just one of many retirement account options, and there are several types to choose from. The right choice will depend on your individual retirement goals and timeline, as well as your expectations for future taxes.

If you're not sure which retirement account or type of IRA to go with, consider speaking to a financial advisor or tax professional. They can point you in the right direction.

Aly J. Yale

Aly J. Yale is a freelance writer, specializing in real estate, mortgage, and the housing market. Her work has been published in Forbes, Money Magazine, Bankrate, The Motley Fool, The Balance, Money Under 30, and more. Prior to freelancing, she served as an editor and reporter for The Dallas Morning News. She graduated from TCU's Bob Schieffer College of Communication with a focus on radio-TV-film and news-editorial journalism. Connect with her on TwitterorLinkedIn.

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