Guide to IRAs: What they are and how they work

Individual retirement accounts, or IRAs, are a popular retirement savings option due to their tax advantages and wide range of investment options. However, a limited understanding of how IRAs work may keep some people from opening an account or using one as part of their retirement strategy.

Here are answers to common questions about how IRAs work—from basic IRA benefits to key differences between traditional and Roth accounts—so you can make more informed decisions about your retirement strategy.

What is an IRA?

An IRA is a tax-advantaged account designed to help you save for retirement. Unlike 401(k)s and other workplace retirement plans, certain IRAs aren't tied to an employer—meaning anyone who has earned taxable income during the year may be eligible to contribute.

This flexibility makes IRAs an especially powerful way to save for retirement when you're self-employed. But even if you already participate in an employer-sponsored plan, an IRA can help supplement your savings and grow your retirement nest egg in a tax-efficient way.

How do IRAs work?

IRAs function similar to traditional brokerage accounts. They allow you to invest in a variety of assets, including stocks, bonds, mutual funds and exchange-traded funds, or ETFs.

The key difference is that IRAs are specifically designed for retirement savings, which means they come with some significant tax benefits—as well as certain rules and limitations. For example, annual contributions are capped by the IRS, and Roth IRAs carry income restrictions. Likewise, any withdrawals taken before age 59 1/2 may be subject to taxes and an early-withdrawal penalty, with limited exceptions.

The upside is that IRAs offer powerful tax benefits. Depending on the type of IRA you choose, your investments can grow tax-deferred or you can qualify for tax-free withdrawals in retirement. These potential tax advantages are one of the biggest IRA benefits for many individuals.

Types of IRAs

There are two primary types of IRAs—traditional IRAs and Roth IRAs. The most significant difference between them is when you receive the tax benefit.

• Traditional IRAs offer tax-deferred growth. Depending on your income and whether you're covered by a workplace retirement plan, you may be able to deduct contributions to a traditional IRA on your annual tax return. However, withdrawals in retirement are generally taxed as ordinary income.
• Roth IRAs work in reverse. Contributions are made with after-tax dollars, but qualified withdrawals in retirement—including your earnings—are tax-free.

Traditional and Roth IRAs aren't the only options, though.

• SEP IRAs are a popular option for self-employed individuals and small business owners. Employers can contribute up to 25% of each employee's compensation, up to a maximum, which is adjusted annually for inflation.
• SIMPLE IRAs are designed for employers with 100 or fewer employees. Both the business and participating employees can contribute to a SIMPLE IRA. Contributions made by the business are fully tax-deductible.

Is a traditional IRA or a Roth IRA better?

Both traditional and Roth IRAs offer valuable tax benefits. The right option for you will likely depend on your current income, tax situation and expectations for your future tax rate.

A traditional IRA may make sense if you expect to be in a lower tax bracket in retirement. Eligible contributions are tax-deductible today, providing the greatest benefit when your current tax rate is higher. Once you reach retirement, withdrawals are generally taxed as ordinary income—potentially at a lower rate.

However, a Roth IRA may be a better fit if you expect your tax rate to be higher in retirement than it is now, or if you'd prefer the certainty of tax-free income later. This is because you contribute with after-tax dollars today, but qualified withdrawals in retirement—including earnings—are tax-free.

There are other factors to consider when choosing an IRA, including eligibility requirements. Exploring key differences between a traditional and Roth IRA can help you determine which option is the best fit for your needs.

How to set up an IRA

The steps to open an IRA are fairly straightforward. Unless you already have a financial institution in mind, your first step should be to decide where you'd like to open your account. Popular options include banks, brokerages and investment firms.

As you research your options, be sure to consider factors like:

• Account fees and trading commissions
• Minimum balance requirements
• Available investment options
• Access to tools, education and professional guidance

You'll also need to decide how involved you'd like to be. A self-directed IRA may be a good fit if you'd like to select and monitor your own investments. If you prefer a more hands-off approach, however, a robo-advisor or fully managed account may be ideal.

How much can you contribute to an IRA?

IRAs are subject to annual contribution limits set by the IRS. If you're 50 or older, you may also be eligible to make additional catch-up contributions. These limits apply across all IRAs you own, and your combined contributions can't exceed the annual limit.

Because contribution limits and eligibility thresholds can change yearly, it's important to stay up to date. Our guide to annual retirement plan contribution limits outlines the latest updates and rules.

There are also a few eligibility rules worth considering.

• Eligibility to contribute to a Roth IRA begins to phase out at certain income levels and is prohibited above these thresholds.
• Contributions to a traditional IRA may not be fully tax-deductible if you or your spouse have access to an employer-sponsored retirement plan—even if you don't participate—and your income exceeds IRS limits.

IRA investment options

Opening and funding an IRA is just the first step. To help your savings grow, you'll need to choose how the money inside the account is invested.

Your investment mix should reflect your risk tolerance, time horizon and retirement goals. Generally, younger investors with decades until retirement may lean more heavily toward stocks for growth potential, while those closer to retirement often shift toward bonds, CDs and other lower-volatility investments. Many investors use a diversified mix of stocks, bonds and cash equivalents to balance growth and stability.

Depending on your provider, you may be able to invest in mutual funds, ETFs, individual stocks and bonds, money market funds or IRA CDs. If you prefer a hands-off approach, a target-date fund or professionally managed IRA can automatically adjust your allocation over time.

If you're fairly new to investing, learning more about how to choose IRA investments—including how to assess your risk tolerance, build an asset allocation and diversify your portfolio—can be helpful.

Common questions about IRAs

Whether you're comparing IRA options, managing an existing account or deciding what to do with inherited funds, certain rules may affect your next steps. Explore answers to frequently asked questions about IRAs to better understand your options.

Is an IRA a good investment?

An IRA itself isn't an investment—it's an account that holds investments. However, an IRA can be an excellent way to boost your retirement savings, particularly because of the tax advantages these accounts provide.

To make the most of your IRA:

• Start early to take advantage of compound growth
• Contribute as much as your budget allows, up to annual IRS limits
• Build a diversified mix of investments to help manage risk
• Opt for low-cost funds to minimize fees
• Automate your contributions to stay consistent
• Review and rebalance your portfolio at least annually

Keep in mind that investing always involves some level of risk. Your IRA balance will fluctuate with market conditions, and losses are possible. But historically, a well-diversified IRA focused on long-term growth has been an effective way to build retirement savings.

What is a rollover IRA?

A rollover IRA is an individual retirement account that contains funds transferred from a qualified employer-sponsored retirement plan, such as a 401(k), after you leave a job or choose to move your savings. The rollover allows you to keep your retirement funds tax-advantaged while shifting them into an IRA.

While there are a few important considerations—like maintaining tax-deferred status and choosing the right type of IRA—a rollover can offer several benefits. These may include more control over your investments, a broader range of investment options and the convenience of consolidating multiple retirement accounts into one place for easier management.

What is a spousal IRA?

A spousal IRA is a strategy that allows a married couple to contribute to an IRA on behalf of a spouse who has little or no earned income. As long as one spouse has sufficient earned income and the couple files a joint tax return, a nonworking spouse can contribute to an IRA in their own name. Contribution limits and eligibility rules are the same as for traditional and Roth IRAs, and income thresholds may affect whether contributions are deductible or allowed.

How does an IRA pay out?

Once you reach age 59 1/2, you can begin taking withdrawals from a traditional IRA without any penalty. Before this, you'll be hit with a 10% early-withdrawal penalty in addition to ordinary income taxes. No matter when you take distributions from a traditional IRA, the amount is taxed as income at your current tax rate.

Traditional IRAs are also subject to required minimum distributions, or RMDs. Depending on your birth year, you must begin taking RMDs at age 73 or 75. The required amount is calculated based on your account balance and life expectancy.

Roth IRAs work a bit differently. You can withdraw your original contributions at any time, for any reason, without taxes or penalties. And if you're age 59 1/2 and have held your account for at least 5 years, you can also withdraw your earnings tax-free and penalty-free. Unlike traditional IRAs, Roth IRAs aren't subject to RMDs during the original account owner's lifetime.

Beyond these basic guidelines, there are many nuances to taking IRA distributions—including exceptions to the early-withdrawal penalty and strategies for minimizing your tax liability. Be sure to understand all the rules before tapping into your IRA.

Can I manage my own IRA?

With a self-directed investing platform, you can choose your IRA investments and manage your account on your own. This approach offers maximum flexibility and control, but it also means you're responsible for thoroughly researching investments and maintaining your portfolio over time.

If you'd like a bit more guidance, a robo-advisor may be another option worth considering. These automated IRAs leverage technology to offer generalized investment advice. As a result, they typically have lower fees than a fully managed IRA.

If you'd prefer professional guidance, a managed IRA may be a better option. With this arrangement, you'll pay a fee for advisors to help select investments and manage the account over time. Managed IRAs may also be a good choice if you'd like access to more sophisticated investment strategies.

What should I do with an inherited IRA?

The rules for inherited IRAs depend on your relationship to the original account owner. Spouses have the most flexibility—they can take ownership of the IRA and treat it as their own, roll it into another retirement account or take distributions as a beneficiary.

Non-spouses, on the other hand, are subject to vastly different rules. Generally, beneficiaries must liquidate inherited accounts within 10 years unless they qualify for an exception, such as being a minor child of the original IRA owner or being no more than 10 years younger. Having a long-term disability or chronic illness may qualify someone for an exception as well. Still, there are a few nuances to keep in mind. For example, once a child of an IRA owner turns 21, they must follow the 10-year rule.

No matter your situation, it's wise to consult a tax or financial advisor after inheriting an IRA. These accounts come with unique restrictions and tax implications that can be tricky to navigate on your own.

The bottom line

IRAs are a cornerstone of retirement planning for millions of Americans—and for good reason. By offering valuable tax benefits and a diverse range of investment options, these accounts can be a powerful tool for building long-term wealth.

As with any strategy for retirement savings, careful planning and diligent saving are key to success. If you're unsure how to start saving for retirement, reach out to a financial advisor. They can help you create a plan that's tailored to your personal financial situation, risk tolerance and long-term objectives.