What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged investing tool that individuals use to earmark funds for retirement savings. There are several types of IRAs as of 2019: traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

Key Takeaways

  • IRAs are investing tools for individuals to earmark their retirement savings.
  • Depending on the individual’s employment status, IRAs can be of different types and have different tax liabilities.
  • If you withdraw money from an IRA prior to age 59½, you are in most cases subject to an early withdrawal penalty of 10%.

Understanding Individual Retirement Accounts (IRAs)

So how does an IRA work? IRAs are sometimes referred to as individual retirement arrangements, because investments held in IRAs can encompass a range of financial products, including stocks, bondsETFs, and mutual funds. A self-directed IRA is a type of traditional or Roth IRA that allows investors to make all of the investment decisions for their account and affords access to an even broader range of investments, including real estate, private placements, and tax liens.

Individual taxpayers establish traditional and Roth IRAs, while small-business owners and self-employed individuals establish SEP and SIMPLE IRAs. An IRA must be established with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Generally, individuals open IRAs with brokers.

Note that you can only contribute to an IRA with earned income that meets IRA rules. Income from investments, Social Security benefits, or child support doesn't count as "earned income," for example.

Because IRAs are meant for saving for your retirement, there is an early withdrawal penalty of 10% if you take money out prior to age 59½, except in certain allowable instances. Depending on the kind of IRA you have, you could also have to pay income tax on your early withdrawal, a double whammy you should try hard to avoid.

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Roth IRA Vs. Traditional IRA

Types of Individual Retirement Accounts (IRAs)

As noted above, there are four basic types of IRA accounts, and they are:

Traditional IRA

In most cases contributions to traditional IRAs are tax deductible. If someone contributes $6,000 to an IRA, for example, that person's taxable income will be reduced by the amount of the contribution. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. As of 2019 annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you’re 50 or older, you can contribute up to $7,000 per year using catch-up contributions.

For 2020, the IRS has left the contribution limits unchanged, but changed the income phase out range from $103,000 - $123,000 to $104,000 - $124,000 for married couples, and $64,000 - $74,000 to $65,000 - $75,000 for singles.

Your income and whether you have a retirement plan at work determine which types of IRAs you can open and whether your contributions will be tax deductible.

How deductible your traditional IRA contributions are can depend on whether your employer offers a retirement plan. As of 2019, if you’re a single person or file as head of household with a retirement plan, such as a 401(k) or 403(b), available through work and a modified adjusted gross income (MAGI) of $64,000 or less, your IRA contributions are fully deductible. If you’re married filing jointly, the limit is $103,000 or less. If you earn more, you begin to lose deductions. Use this chart to figure out where you fit:

2019 Deduction Limits If You Have a Retirement Plan at Work
Filing Status Modified AGI Deduction
Single or Head of Household    
  $64,000 or less Full deduction up to your contribution level
  More than $64,000 but less than $74,000 Partial deduction
  $74,000 or more No deduction
Married Filing Jointly    
  $103, 000 or less Full deduction up to your contribution level
  More than $103,000 but less than $123,000 Partial deduction
  $123,000 or more No deduction
Married Filing Separately    
  Less than $10,000 Partial deduction
  $10,000 or more No deduction
Source: IRS Website

It’s also worth noting that, beginning at age 70½, 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. What's more, after RMDs begin, people can no longer contribute to a traditional IRA.

Roth IRA

Roth IRA contributions are not tax deductible, but qualified distributions are tax free. This means that you contribute to a Roth IRA using after-tax dollars, but as the account grows you do not face any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roths also do not have RMDs. If you don't need the money, you don’t have to take it out of your account or worry about penalties for failing to do so. Also useful: You can contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contributions for 2019 are the same as for traditional IRAs: $6,000 unless you are 50 or older and can qualify for the catch-up contribution that raises the limit to $7,000. The catch: Not everyone qualifies to contribute to a Roth IRA; there are income limitations. As of 2019 tax filers who are married and file jointly, for example, can contribute up to the annual contribution limit if their combined MAGI is less than $193,000; the figure for those filing as single or head of household is $122,000. The details are below:

2019 Income Limitations for Contributing to a Roth IRA
Filing Status Modified AGI Contributions
Single or Head of Household    
  Less than $122,000 Up to the limit
  $122,000 to less than $137,000 Reduced amount
  $137,000 or more Zero
Married Filing Jointly or Qualifying Widow(er)    
  Less than $193,000 Up to the limit
  $193,000 to less than $203,000 Reduced amount
  $203,000 or more Zero
Married Filing Separately    
  Less than $10,000 Reduced amount
  $10,000 or more Zero
Source: IRS Website

Note: For both types of IRAs, if your tax status is married filing separately and you have not lived with your spouse for any portion of the entire tax year, you qualify for the deduction and income limits of a single person.

For 2020, the IRS has left the contribution limits the same, but increased the income phase out levels by $1000 for both singles and married couples.

SEP IRA

Self-employed individuals, such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs (the acronym stands for “simplified employee pension”). A SEP IRA adheres to the same taxation rules for withdrawals as a traditional IRA. For 2019 SEP IRA contributions are limited to 25% of compensation or $56,000, whichever is less. 

Business owners who set up a SEP IRA for the company’s employees can deduct the contributions from their reported business income and potentially secure a lower tax rate on that income. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA (the acronym stands for “savings inventive match plan for employees”) is also intended for small businesses and self-employed individuals. It, too, follows the same taxation rules for withdrawals as a traditional IRA. 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, which can reduce one’s tax bill. The SIMPLE IRA employee contribution limit for 2019 is $13,000, with a $3,000 catch-up contribution allowed for savers age 50 and older.

Compare the Options

Use this chart to get a better sense of how the different IRAs work. Note that traditional and Roth IRAs require employment income, but individual taxpayers choose whether to open one, if they qualify. SEP IRAs and SIMPLE IRAs require your employer to set up the plan; unless you are self-employed, you can’t establish one on your own.

[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 (2019)

 

Tax-Deductible Contributions?

 

Tax-Free Distributions?

 

Subject to Required Minimum Distributions Beginning at Age 70½?

 

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 $56,000

 

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

 

$13,000; $16,000 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