What an IRA Is and How It Works for Your Retirement

An IRA is a tax-advantaged account you open at a bank, brokerage, or credit union to save for retirement

An Individual Retirement Account (IRA) is a savings account with special tax rules that make it easier to build retirement money over time. You open one yourself—not through an employer—and you decide how much to put in each year, what to invest it in, and when to take it out. The tax advantage is the point: depending on which type of IRA you choose, your contributions may reduce your taxable income now, or your withdrawals may be tax-free later.

IRAs come in two main flavors: Traditional and Roth. Both let your money grow without paying taxes on the gains year to year. The difference is when you get the tax break—upfront with a Traditional IRA, or at withdrawal with a Roth. Which one makes sense depends on your income now versus what you expect in retirement.

Key Takeaways

• A Traditional IRA lets you deduct contributions from your taxes now, but you pay income tax when you withdraw the money in retirement.
• A Roth IRA takes after-tax dollars now, but withdrawals in retirement are completely tax-free if you follow the rules.
• You can contribute up to $7,000 per year to an IRA (or $8,000 if you are 50 or older), though income limits apply to Roth contributions and Traditional deductions if you have a workplace retirement plan.
• Money in an IRA must stay there until age 59½ to avoid a 10% early withdrawal penalty, with a few exceptions like first-time home purchase or medical hardship.
• You choose where to open your IRA—a bank, brokerage, or credit union—and you pick what to invest in, whether that is stocks, bonds, mutual funds, or cash.

How a Traditional IRA works

With a Traditional IRA, you contribute money that may be tax-deductible in the year you put it in. If your income is below certain thresholds and you do not have a workplace 401(k) or similar plan, you can deduct the full amount. If you do have a workplace plan, the deduction phases out as your income rises—the exact income limits depend on your filing status and change each year.

Your money then grows tax-free inside the account. You do not pay taxes on dividends, interest, or capital gains as long as the money stays in the IRA. When you turn 59½, you can withdraw money whenever you want, and you pay ordinary income tax on whatever you take out. If you withdraw before 59½, you owe a 10% penalty on top of income tax, unless you meet a narrow exception like a first-time home purchase (up to $10,000 lifetime) or a medical hardship.

At age 73, you must start taking Required Minimum Distributions (RMDs)—the IRS calculates how much you have to withdraw each year based on your age and account balance. You pay income tax on these withdrawals whether you need the money or not.

How a Roth IRA works

A Roth IRA flips the tax timing. You contribute money that has already been taxed—no deduction now. But once the money is in the account, it grows tax-free, and when you withdraw it in retirement, you owe no income tax at all, as long as the account has been open for at least five years and you are 59½ or older.

The catch is income limits. If your income exceeds a certain threshold, you cannot contribute to a Roth IRA directly. Those limits vary by filing status and change yearly. If you earn too much for a direct Roth contribution, some people use a "backdoor Roth" strategy—contributing to a Traditional IRA and then converting it to a Roth—though this has tax complications if you already have Traditional IRA balances.

Unlike a Traditional IRA, there are no Required Minimum Distributions during your lifetime. You can leave the money untouched as long as you want, which makes a Roth useful if you want to pass retirement savings to heirs. You can also withdraw your contributions (not earnings) at any time without penalty, though this defeats the purpose of saving for retirement.

Where to open an IRA and what to invest in

You can open an IRA at almost any financial institution: a bank, a brokerage like Fidelity or Vanguard, a credit union, or an online investment platform. Each charges different fees and offers different investment options, so it is worth comparing before you choose. Some banks offer only savings accounts or CDs inside an IRA; brokerages let you buy stocks, bonds, mutual funds, and exchange-traded funds (ETFs).

Once your account is open, you decide what to invest in. You are not required to pick individual stocks—many people choose a target-date fund, which automatically shifts from stocks to bonds as you approach retirement, or a simple index fund that tracks the whole market. The institution you choose will have a menu of options available to you.

Annual contribution limits and income rules

For 2024, you can contribute up to $7,000 per year to an IRA, or $8,000 if you are 50 or older (the extra $1,000 is called a "catch-up" contribution). These limits apply across all your IRAs combined—if you have both a Traditional and a Roth, your total contributions to both cannot exceed the annual limit.

You can only contribute money you earned from work that year. If you had no income, you cannot contribute. If you are married and one spouse does not work, the working spouse can contribute to a spousal IRA in the non-working spouse's name, up to the same limit.

For a Roth IRA, there are income phase-out ranges. If your Modified Adjusted Gross Income (MAGI) exceeds the limit for your filing status, you cannot contribute the full amount, and above a higher threshold, you cannot contribute at all. For a Traditional IRA, the deduction phases out if you have a workplace retirement plan and your income is above certain thresholds. The IRS publishes these limits each year.

Penalties and exceptions for early withdrawal

If you withdraw money from a Traditional IRA before age 59½, you typically owe a 10% penalty plus income tax on the amount withdrawn. A Roth IRA lets you withdraw your contributions (the money you put in) anytime without penalty, but earnings are subject to the same 10% penalty if you are under 59½.

The IRS does allow some exceptions to the penalty. You can withdraw up to $10,000 lifetime for a first-time home purchase, or you can withdraw for certain medical expenses, health insurance premiums during unemployment, or disability. Some people also use a "72(t) distribution" strategy to take regular equal payments before 59½ without penalty, though this requires following strict rules. If you think an exception might apply to you, check the IRS rules or speak with a tax professional before withdrawing.

Traditional versus Roth: which makes sense for you

Choose a Traditional IRA if you want to reduce your taxable income now and expect to be in a lower tax bracket in retirement. This works well if you are self-employed, have high income this year, or are close to retirement and want immediate tax relief.

Choose a Roth IRA if you expect to be in a higher tax bracket later, or if you want tax-free withdrawals and flexibility in retirement. Roth accounts are also better if you want to pass money to heirs tax-free, or if you want the option to withdraw contributions without penalty. Younger people often benefit from a Roth because they have decades for tax-free growth ahead.

Some people contribute to both types over time, which is allowed as long as your total contributions do not exceed the annual limit. A financial advisor or tax professional can help you decide based on your specific situation.

Frequently Asked Questions

Can I have both a Traditional and a Roth IRA at the same time?

Yes. You can have both accounts open, but your total contributions to all IRAs combined cannot exceed the annual limit. If you contribute $4,000 to a Traditional IRA, you can only contribute $3,000 to a Roth that year (assuming the $7,000 limit applies to you).

What happens to my IRA if I change jobs?

Your IRA stays with the institution where you opened it—it is not tied to your employer. If your new employer offers a 401(k), you can keep your IRA separate or roll the 401(k) into an IRA if you leave that job. Rolling a Traditional 401(k) into a Traditional IRA is usually tax-free, but rolling a Roth 401(k) into a Roth IRA requires careful handling.

Can I withdraw money from my IRA to pay off debt?

You can withdraw money, but you will owe income tax and likely a 10% penalty if you are under 59½. The exception is if the debt qualifies as a hardship—medical bills, for example—but credit card debt or a personal loan does not. It is almost always cheaper to pay off debt another way than to raid your retirement account.

Do I have to open an IRA with the same bank where I have my checking account?

No. You can open an IRA anywhere. Many people choose a brokerage instead of a bank because brokerages offer more investment options. Compare fees, available investments, and customer service before deciding.

What if I earn too much to contribute to a Roth IRA?

If your income exceeds the Roth limit, you can still contribute to a Traditional IRA (though the deduction may phase out if you have a workplace plan). Some people use a backdoor Roth strategy, but this involves converting a Traditional IRA to a Roth and has tax consequences if you have other Traditional IRA balances. A tax professional can walk you through whether this makes sense for you.