Individual Retirement Account (IRA): What It Is & How It Works

What is an IRA?

An individual retirement account (IRA) is a tax-advantaged investment account used to save money for retirement. Depending on the type of IRA, contributions grow on either a tax-free or tax-deferred basis.

While an IRA may be especially attractive to those who don't have access to a 401(k) or other employer-sponsored retirement plan, anyone with earned income is eligible to open an IRA as another way to save for retirement.

If you want to invest through an IRA for retirement, you'll need to open an account first. This can be done at a financial institution, such as a bank or online broker.

» Ready to get started? Review the best IRA accounts

How does an IRA work?

An IRA works by taking contributions (up to an annual limit set by the IRS) and investing that money into assets such as stocks, bonds, mutual funds or ETFs.

How your account balance grows over time depends on how much you contribute to the IRA and how you invest. (See how to invest your IRA for simple investment strategies.) As the account holder, you can choose if you want a hands-on approach by selecting your own investments or if you'd like to be hands-off and let others, such as a robo-advisor or financial planner, do the work for you.

There are several types of IRAs, including traditional IRAs and Roth IRAs for individuals, which offer different tax advantages. There's also the SEP IRA and SIMPLE IRA for business owners and self-employed individuals (more on this below). While you can have and contribute to more than one type of IRA, the accounts share a combined annual limit set by the IRS every year.

Lastly, because IRAs are intended to be used for retirement, there are also strict withdrawal rules: You may face a 10% penalty and income taxes if you withdraw money from a traditional IRA before age 59 ½, unless you qualify for an exception^[0]

» Are you on track for retirement? Use our retirement calculator to find out

5 types of IRAs

Here are five popular types of IRAs and an overview of each:

1. Traditional IRA

Contributions to a traditional IRA may be eligible for a tax deduction in the year they're made, which can be an incentive to save for retirement now. For example, contributing $3,000 to a traditional IRA could reduce your taxable income that year by $3,000.

However, taxes are paid eventually in retirement when withdrawals are taxed as ordinary income. Traditional IRAs are also subject to required minimum distributions when you reach a certain age, depending on the year you were born. This means that from that point forward, you must withdraw money from the account every year.

» MORE: Learn more about traditional IRAs

2. Roth IRA

While contributions to Roth IRAs aren't tax-deductible (though you can withdraw those contributions penalty- and tax-free at any time), the main draw is that the money grows tax-deferred and can be withdrawn tax-free in retirement.

“The question is, do you want to pay your taxes now or later? For me, I’d rather pay taxes now,” says certified financial planner Matt Aaron, founder of Washington, D.C.-based Lux Wealth Planning, an affiliate of Northwestern Mutual. For that reason, he explains it can be an attractive option for investors who have a long time before they retire.

Roth IRAs can help you combat inflation, Aaron says, because money loses value over time. He says he thinks of a Roth IRA as paying taxes on the seed vs. paying taxes on the harvest.

"I don't have the magic ball, and I can never say I know what’s going to happen in the future, but if taxes go up, and you’re taking that money out in the future, you get to potentially minimize the taxes you pay.”

There are income limits for Roth IRAs, so the amount you can contribute decreases and is eventually eliminated at certain incomes. If you earn too much to contribute to a Roth IRA, you can try the backdoor Roth method instead.

» MORE: Learn more about Roth IRAs

3. SEP IRA

Generally, SEP IRAs are for self-employed people or small business owners with few or no employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.

In 2024, contributions are limited to 25% of compensation or $69,000 ($70,000 in 2025). There's no catch-up contribution at age 50 or older. SEP IRAs require proportional contributions for each eligible employee if business owners contribute for themselves^[0]

» MORE: Learn more about SEP IRAs

4. SIMPLE IRA

SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) are for small businesses with fewer than 100 employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.

Employee contribution limits for a SIMPLE IRA in 2024 are $16,000, with a catch-up contribution of $3,500 for those 50 or older. That contribution limit is $16,500 in 2025. The catch-up contribution is unchanged in 2025 for most people. Secure 2.0 Act allows for a higher catch-up amount for those age 60 to 63, as well as higher overall and catch-up limits for participants in certain applicable plans.

» MORE: Learn more about SIMPLE IRAs

5. Rollover IRA

A rollover IRA isn’t a type of IRA account but a process in which you can transfer eligible assets from an employer-sponsored plan, such as a 401(k), into an IRA. People tend to do this when they're switching jobs so they can house all of their money in one place.

» MORE: Learn more about rollover IRAs

IRA benefits

A big benefit of an IRA is that the money you invest grows either tax-free or tax-deferred.

• If you contribute to a traditional IRA, you may get a tax deduction on your contributions in the year they are made; you'll then pay taxes when you take distributions in retirement.

• If you contribute to a Roth IRA, you do not receive an immediate tax deduction or benefit, but your retirement distributions are tax-free.

But the tax advantages are not the only perk.

“The main benefit of an IRA is your ability to have more investment options and choices,” says Aaron.

An employer-sponsored 401(k) may have limited investments or may not let you choose your own. And a 401(k) or pension alone may not provide enough money for you in retirement. Contributing to an IRA can offer you more access to investment options, increased retirement income and, yes, tax savings.

IRA contribution limits for 2024 and 2025

One downside of IRAs is that annual contributions are quite low and generally not enough to fund retirement on their own. For Roth and traditional IRAs — the most common types of individual IRAs — you can contribute up to $7,000 in 2024 and 2025 ($8,000 if age 50 and older). Both types of accounts also have additional restrictions:

• If you or your spouse have a retirement plan at work, such as a 401(k), your ability to deduct traditional IRA contributions may be reduced or eliminated. Learn more about the traditional IRA income and deduction limits.

• At certain higher incomes, your ability to contribute to a Roth IRA will be eliminated. The maximum Roth IRA contribution phases down until it is eliminated completely. Learn more about Roth IRA income and contribution limits.

How to open an IRA

Two popular ways to open an IRA are through brokers and robo-advisors. If you want to choose investments for yourself, an online broker can be a good way to go. If you want help managing your retirement account, consider a robo-advisor — a service that selects low-cost and risk-appropriate investments for you.

» Want a detailed overview? Here's our guide on how to open an IRA.

Frequently asked questions

What does "IRA" stand for?

IRA stands for individual retirement arrangement. That’s the official name given by the IRS, but most people think of IRAs as individual retirement accounts, and that’s exactly what they are. While there are different types of IRAs, all of them are retirement accounts that offer tax benefits to encourage people to save for retirement. Almost all IRAs require you to have income from work.

How much money do you need to start an IRA?

Many discount brokers and robo-advisors have $0 minimums to open an IRA. However, the tax perks of investing in an IRA begin only once you've started contributing money to the account. The maximum the IRS allows you to contribute is up to $7,000 in 2024 and 2025. You can contribute an extra $1,000 per year if you’re age 50 or over. You can contribute the full amount, but it is not required.

You can add money to your IRA at whatever cadence and amount works for your budget. Many brokers and robo-advisors allow investors to set up automatic deposits to transfer money from a bank into an account.

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

You can have both a 401(k) and an IRA. A 401(k) offers more opportunity to increase your retirement savings compared with an IRA due to the higher annual contribution limits.

You could consider investing primarily in an IRA if you don't get an employer match, if you plan to max out your 401(k), or if your 401(k) has narrow investment options or high fees.

Can you lose money in an IRA?