What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged account that individuals use to save and invest for retirement. The Internal Revenue Service (IRS) also uses the term individual retirement arrangements (also IRAs) to broadly refer to individual retirement accounts, individual retirement annuities, and other trusts and custodial accounts that act as personal savings plans with tax advantages for setting aside money for retirement.

There are several types of IRAs—traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has different rules regarding eligibility, taxation, and withdrawals.

Key Takeaways

  • IRAs are tax-advantaged accounts that individuals use to save and invest for retirement.
  • Types of IRAs include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
  • If you withdraw money from an IRA before age 59½, you are usually subject to an early withdrawal penalty of 10%.
  • There are income limitations for contributing to Roth IRAs and for deducting contributions to traditional IRAs.
  • Rules regarding maximum contributions and income limits for IRAs change each year.

Understanding Individual Retirement Accounts (IRAs)

So how does an IRA work? Investments held in IRAs can encompass a range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Self-directed IRAs allow investors to make all the decisions and give them access to a broader selection of investments, including real estate, private placements, and commodities. A self-directed IRA can be a traditional IRA or a Roth IRA.

Individual taxpayers can establish traditional and Roth IRAs, while small-business owners and self-employed individuals can set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received IRS approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Most individual investors open IRAs with brokers.

Your income and whether you have a retirement plan at work influence which types of IRAs you can open and whether your contributions will be tax deductible. Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. Depending on what type of IRA you have, you may also need to pay income tax on your early withdrawal.

You can only contribute to an IRA with earned income that meets IRA rules. Income from interest and dividends, Social Security benefits, or child support does not count as earned income.

Types of Individual Retirement Accounts (IRAs)

The following is a breakdown of the different types of IRAs and the rules regarding each:

Traditional IRA

In most cases, contributions to traditional IRAs are tax deductible. If someone puts $6,000 into an IRA, that person's taxable income decreases by the amount of the contribution. However, when they withdraw money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. For 2021, annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute a total of up to $7,000 per year using catch-up contributions.

For 2021, the IRS changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range for married couples changed from $104,000–$124,000 in 2020 to $105,000–$125,000 and from $65,000–$75,000 to $66,000–$76,000 for singles.

Several key factors determine whether you can deduct your traditional IRA contributions. Suppose you are a single person or file as head of household and have a retirement plan, such as a 401(k) or 403(b), available at work. Your traditional IRA contributions are fully deductible if your modified adjusted gross income (MAGI) was $65,000 or less in 2020. In 2021, the limit is $66,000. If you're married filing jointly, the limit was $104,000 or less in 2020 and is $105,000 in 2021. If you earn more, you begin to lose deductions. Use this chart to figure out where you fit.

Deduction Limits If You Have a Retirement Plan at Work
Filing Status 2020 MAGI 2021 MAGI Deduction
Single or Head of Household      
  $65,000 or less $66,000 or less Full deduction up to your contribution level
  More than $65,000 but less than $75,000 More than $66,000 but less than $76,000 Partial deduction
  $75,000 or more $76,000 or more No deduction
Married Filing Jointly      
  $104,000 or less $105,000 or less Full deduction up to your contribution level
  More than $104,000 but less than $124,000 More than $105,000 but less than $125,000 Partial deduction
  $124,000 or more $125,000 or more No deduction
Married Filing Separately      
  Less than $10,000 Less than $10,000 Partial deduction
  $10,000 or more $10,000 or more No deduction

Starting at age 72, holders of traditional IRAs must begin taking required minimum distributions (RMDs), which are based on their account size and life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement of taking RMDs from 70½ to 72. It also eliminated the age limit for when a person can contribute to an IRA, which was 70½. A person of any age with earned income can now contribute to an IRA.

Typically, taxpayers have until the April 15 tax filing deadline to make an IRA contribution for the prior tax year. Due to the winter storms that hit Texas, Oklahoma, and Louisiana in February 2021, the IRS has delayed the 2020 federal individual and business tax filing deadline for those states to June 15, 2021. This change also pushes the IRA contribution deadline for individuals in these states to June 15.

Roth IRA

Roth IRA contributions are not tax deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not have to pay any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have RMDs. If you don't need the money, you don't have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits for 2020 and 2021 tax years are the same as for traditional IRAs. However, there is a catch. There are income limitations for contributing to a Roth IRA. The phaseout range for single filers was between $124,000 and $139,000 in 2020 and is between $125,000 and $140,000 in 2021. For married couples filing joint taxes, the phaseout range was $196,000 to $206,000 in 2020 and is $198,000 to $208,000 in 2021.

Income Limits for Contributing to a Roth IRA
Filing Status 2020 MAGI 2021 MAGI Contributions
Single or Head of Household      
  Less than $124,000 Less than $125,000 Up to the limit
  $124,000 to less than $139,000 $125,000 to less than $140,000 Reduced amount
  $139,000 or more $140,000 or more Zero
Married Filing Jointly or Qualifying Widow(er)      
  Less than $196,000 Less than $198,000 Up to the limit
  $196,000 to less than $206,000 $198,000 to less than $208,000 Reduced amount
  $206,000 or more $208,000 or more Zero
Married Filing Separately      
  Less than $10,000 Less than $10,000 Reduced amount
  $10,000 or more $10,000 or more Zero

SEP IRA

Self-employed individuals, such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for simplified employee pension. A SEP IRA adheres to the same taxation rules for withdrawals that a traditional IRA does. For 2021, SEP IRA contributions are limited to 25% of compensation or $58,000, whichever is less.

Business owners who set up SEP IRAs for their employees can deduct the contributions they make on behalf of employees. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for savings incentive match plan for employees. This type of IRA follows the same tax rules for withdrawals that a traditional IRA does.

Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax deductible, potentially pushing the business or employee into a lower tax bracket. The SIMPLE IRA employee contribution limit in 2021 is $13,500, and the catch-up limit (for workers age 50 and older) is $3,000, the same as it was in 2020.

In 2008, the IRS issued Revenue Ruling 2008-5, which states that IRA transactions can also trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by substantially identical shares purchased in an IRA within a 30-day period, the investor cannot claim tax losses for the sale. The investment's basis in the individual's IRA won't be increased either.

Comparing IRA Options

Use the chart below to get a better sense of how the different IRAs work.

Note: To see the full chart, use the slider at the bottom to see the column at the far right.

Comparing IRA Types
 
IRA Type
 
Employee ​Contribution Limit (2021)
 
Tax-Deductible Contributions?
 
Tax-Free Distributions?
 
Subject to Required Minimum Distributions Beginning at Age 72?
 
Who Can Establish
 
Traditional
 
$6,000; $7,000 if age 50 or older
 
Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer
 
No
 
Yes
 
Individual taxpayers and couples*
 
Roth

$6,000; $7,000 if age 50 or older
 
No
 
Yes
 
No
 
Individual taxpayers and couples*, subject to MAGI limitations
 
SEP
 
The lesser of 25% of compensation or $58,000
 
Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation
 
Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct
 
No
 
Yes
 
Small-business owners and self-employed individuals
 
SIMPLE
 
$13,500; $16,500 if age 50 or older
 
All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible
 
Self-employed individuals can also deduct contributions made to their own SIMPLE IRA
 
No
 
Yes
 
Small-business owners and self-employed individuals

Individual Retirement Account FAQs

What are the different types of individual retirement accounts?

The most basic is a traditional IRA, which anybody can open and make annual contributions on a tax-deferred basis. Roth IRAs instead use after-tax contributions that grow tax-free into the future but are subject to income limitations. SEP and SIMPLE IRAs are intended for business owners or self-employed individuals.

Can I contribute to multiple retirement accounts in the same year?

Yes, but you must be sure that the combined contributions to all your IRAs do not exceed the annual limit amount. You can also contribute to both an IRA and a 401(k) plan that is offered through your employer, which comes with its own set of rules, limitations, and qualifications.

What happens if I withdraw money from an IRA early?

IRAs are meant to be long-term retirement savings accounts, and so they come with early withdrawal penalties. If you take money out of an IRA before age 59½, you will be subject to a 10% penalty and must pay any deferred tax liability owed. So, if you withdraw $10,000 from a traditional IRA and are in the 25% tax bracket, you will pay a $1,000 penalty (10%) plus $2,500 in taxes, leaving you with $6,500. There are certain qualified reasons for making an early withdrawal—such as for a first home or emergency medical expenses—that are not subject to the 10% penalty but would be taxed.

Note that loans are not permitted from IRAs or from SEP and SIMPLE IRA plans. Loans are only possible from qualified plans such as 401(k) or 403(b) accounts. If the owner of an IRA does attempt to borrow from it, the account is no longer classified as an IRA and is subject to all penalties and taxes.

What investments can I hold in an IRA?

IRA investments are self-directed, meaning you make all the investment choices. You may hold stocks, bonds, mutual funds, ETFs, and cash, among other assets. Note that certain investments, including life insurance and collectibles such as art, antiques, gems, coins, or alcoholic beverages, are prohibited from being placed in an IRA, and IRAs can only invest in certain precious metals, such as gold, if they meet specific requirements. 

What happens to my IRA assets when I die?

All IRA accounts require a named beneficiary. If you die before your IRA assets are drawn down, they will pass to your beneficiary. If that beneficiary is under the retirement age, they will be subject to the same IRA distribution and withdrawal rules. For a married couple, the beneficiary is the holder's spouse, unless the spouse agrees in writing that another beneficiary is named.