What an IRA does and why the rules exist

An IRA (Individual Retirement Account) is a bank or investment account that the federal government lets you use to save money for retirement with tax advantages. The government does not contribute to it — you do — but in exchange, the money you put in either reduces your taxes now or grows without being taxed until you withdraw it later. The catch is that the government wants you to leave the money alone until you are 59½ years old, so it charges a penalty if you take it out earlier.

The reason these rules exist is straightforward: the government wants to encourage people to save for retirement instead of spending everything now. By making the account tax-advantaged, it makes saving more attractive. By penalizing early withdrawal, it keeps people from raiding their retirement fund for a car or a vacation.

There are two main types of IRAs — Traditional and Roth — and they work differently. A Traditional IRA lets you deduct contributions from your taxes in the year you make them, but you pay taxes on the money when you withdraw it. A Roth IRA takes money that has already been taxed, but the money grows tax-free and you do not pay taxes on withdrawals in retirement. Which one makes sense depends on whether you think your tax rate will be higher now or later.

Key Takeaways

  • You fund an IRA yourself with money from your paycheck or savings; the government does not put money in.
  • A Traditional IRA reduces your taxes in the year you contribute, but you pay taxes on withdrawals later; a Roth IRA takes after-tax money now but lets it grow tax-free.
  • You cannot withdraw money before age 59½ without paying a 10 percent penalty on top of income taxes, with limited exceptions.
  • You must start taking withdrawals from a Traditional IRA at age 73, but Roth IRAs have no required withdrawal age during your lifetime.
  • An IRA is separate from a workplace retirement plan like a 401(k), though you can have both.

How money goes into an IRA

You open an IRA at a bank, credit union, or investment firm — the same places that offer regular savings accounts. You choose whether you want a Traditional or Roth IRA when you open it. Once the account is open, you transfer money into it from your checking account, savings account, or paycheck.

There is a limit to how much you can put in each year. For 2024, that limit is $7,000 if you are under 50, and $8,000 if you are 50 or older. This is a combined limit across all your IRAs — if you have two IRAs, the $7,000 total is split between them, not $7,000 in each. You can contribute less than the limit, or nothing in a given year, but you cannot exceed it.

The money you contribute can come from any source: your job, self-employment income, a bonus, or even money you inherited. The only requirement is that you have earned income in that year — you cannot fund an IRA with investment returns, gifts, or unemployment benefits. If you are married and your spouse does not work, you can still fund an IRA for them using your earned income, but the total across both accounts still hits the annual limit.

How a Traditional IRA reduces your taxes

When you contribute to a Traditional IRA, you can deduct that contribution from your taxable income for that year. If you earn $60,000 and contribute $7,000 to a Traditional IRA, you only report $53,000 as taxable income. This means you pay income tax on $53,000 instead of $60,000, which lowers your tax bill immediately.

The money inside the account then grows — whether through interest, dividends, or investment gains — and you do not pay taxes on that growth while the money sits in the account. This is the tax advantage: your money compounds without being eaten by taxes each year.

When you withdraw money in retirement, you pay income tax on the full amount you withdraw, including all the growth. If you withdraw $50,000 from your Traditional IRA at age 65, you owe income tax on that $50,000 in that year. The idea is that you will be in a lower tax bracket in retirement than you were while working, so you will pay less tax overall — but that is not may provide.

How a Roth IRA grows tax-free

A Roth IRA works backwards. You contribute money that has already been taxed — you do not get a deduction. If you earn $60,000 and contribute $7,000 to a Roth, you still owe taxes on the full $60,000. You are using after-tax dollars.

The advantage comes later. The money grows inside the account without being taxed, just like a Traditional IRA. But when you withdraw money in retirement, you owe no income tax on any of it — not on your contributions, and not on the growth. If your $7,000 contribution grows to $50,000 over 30 years, you withdraw the full $50,000 tax-free.

This makes a Roth useful if you expect to be in a higher tax bracket in retirement, or if you simply want the certainty of knowing your withdrawals will not be taxed. It also means you can leave money in a Roth longer without being forced to withdraw it, which is useful if you do not need the money right away.

The early withdrawal penalty and when you can break the rules

If you withdraw money from either type of IRA before age 59½, you owe a 10 percent penalty on the amount withdrawn, plus you owe income tax on it. If you withdraw $10,000 early from a Traditional IRA, you pay $1,000 in penalty plus income tax on the $10,000 — a significant hit.

There are exceptions. You can withdraw from a Traditional IRA without penalty if you use the money for a first home purchase (up to $250,000 lifetime), higher education expenses, medical insurance while unemployed, or large medical expenses. You can also withdraw if you become disabled or if you set up a series of equal payments based on your life expectancy. A Roth IRA lets you withdraw your contributions (not the growth) anytime without penalty, since you already paid taxes on them.

These exceptions exist, but they are narrow. The general rule is: leave the money alone until 59½, or pay a penalty. Do not open an IRA expecting to raid it early.

Required withdrawals and what happens at age 73

The government wants you to eventually take the money out and pay taxes on it (or in the case of a Roth, to stop sheltering money from taxes indefinitely). Starting at age 73, you must withdraw a minimum amount from a Traditional IRA each year, calculated based on your age and account balance. This is called a Required Minimum Distribution or RMD. If you do not take it, you owe a 25 percent penalty on the amount you should have withdrawn.

A Roth IRA has no required withdrawal age during your lifetime. You can leave the money in the account to grow for as long as you live, and your heirs inherit it tax-free. This is one reason some people prefer Roths — they offer more flexibility in retirement.

If you have multiple IRAs, you calculate the RMD for each one separately, but you can withdraw the total from just one account if you want. You do not have to withdraw equal amounts from each IRA.

How an IRA differs from a 401(k) or workplace plan

An IRA is your own account that you open and manage. A 401(k) or similar workplace retirement plan is offered by your employer, and your employer may contribute to it or match your contributions. The two are separate, and you can have both.

A 401(k) usually has higher contribution limits than an IRA — for 2024, you can contribute up to $23,500 to a 401(k) versus $7,000 to an IRA. A 401(k) also lets your employer match your contributions, which is assistance programs. An IRA does not have employer matching because there is no employer involved.

If you leave a job, you can roll the 401(k) balance into an IRA, which gives you more control over how the money is invested. Many people do this when they change jobs. You cannot roll an IRA into a 401(k) — the money stays in the IRA.

Frequently Asked Questions

Can I have both a Traditional IRA and a Roth IRA?

Yes, but your annual contribution limit applies across both accounts combined. If you have a Traditional IRA and a Roth IRA, you can split the $7,000 annual limit between them however you want — $5,000 in one and $2,000 in the other, for example — but you cannot contribute $7,000 to each.

What happens to my IRA if I die?

Your IRA passes to your beneficiary, usually a spouse or child. A spouse can roll it into their own IRA or treat it as their own. Non-spouse beneficiaries must withdraw the money, though they have up to 10 years to do so. The tax treatment depends on the type of IRA and the beneficiary's relationship to you.

Can I move money from one IRA to another?

Yes. You can transfer money between IRAs at different banks or investment firms. You can also do a rollover, which means you withdraw the money and deposit it elsewhere within 60 days. If you miss the 60-day window, it counts as a withdrawal and you owe taxes and penalties.

What if my income is too high to contribute to an IRA?

Income limits apply to Roth IRAs if you have a workplace retirement plan. Traditional IRAs have no income limit for contributions, but the tax deduction phases out if your income is high and you have a workplace plan. A financial advisor or tax professional can tell you whether you are affected.

Do I pay taxes on IRA growth every year?

No. That is the whole point of an IRA — the growth inside the account is not taxed annually. You only pay taxes when you withdraw the money (Traditional IRA) or not at all (Roth IRA). This is different from a regular investment account, where you owe taxes on dividends and capital gains each year.