What Is an Individual Retirement Account?

An IRA, or individual retirement account, allows you to save money for your retirement while taking advantage of tax breaks. You can set up an IRA through a bank or other financial service provider and enjoy tax-free or tax-deferred growth of your retirement savings.

What Is an IRA?

The term IRA is used to describe individual retirement accounts and the Internal Revenue Service’s broader definition of individual retirement arrangements.

An individual retirement account is a type of individual retirement plan that offers tax advantages for people saving for retirement.

Depending on the type of IRA you have, you may make contributions to the plan now, but not have to pay taxes until you withdraw money from the IRA. Or you may contribute after tax money now and have no taxes to pay on money you withdraw from the IRA after you retire.

You can contribute earnings each year up to a maximum amount allowed by the IRS.

Rolling Over Your 401(k) Into an IRA

IRAs are also an option to consider if you have accumulated money in your employer’s 401(k) plan and you leave your job, whether you are retiring or taking a new job. You may want to consider a rollover.

The term “rollover” describes a tax-free distribution or movement of your assets from one retirement plan to another. Moving the money into the second plan is called a “rollover contribution.”

You can choose to move the assets to your new employer’s retirement plan, leave them where they are, cash out your assets or roll them over into an IRA.

How IRAs Work

Unlike 401(k) plans, which are retirement accounts set up by your employer, IRAs are retirement plans that you set up on your own through a financial institution or advisor.

Where to Set up an IRA
  • Banks or other financial institutions
  • Life insurance companies
  • Mutual funds
  • Stock brokerage firms

Once you open an IRA, you invest money into the IRA account. You can invest in stocks, bonds or other assets that can grow your investment.

You can continue contributing to keep your IRA investments growing, but there is a maximum amount of money you can invest each year.

You can withdraw money from your IRA at any time, but if you do it before you are 59.5 years old, you can face a penalty equal to 10 percent of your withdrawals and get hit with a tax bill for the money you take out.

Did You Know?
The CARES Act, passed in response to the COVID-19 pandemic, temporarily eliminated the 10 percent penalty for certain people making early withdrawals from traditional IRAs in 2020. One-third of the money withdrawn will be counted as income over the next three years, meaning people have to pay income taxes on the withdrawals.

The Four Main Types of IRAs

There are several different types of IRAs, but most fall into one of four different types: Traditional, Roth, SEP or SIMPLE IRAs.

Most Common Types of Individual Retirement Accounts
Traditional IRA
Contributions you make to a traditional IRA are usually tax-deductible and you pay no taxes on IRA earnings until you retire and withdrawals are taxed as your income.
Roth IRA
Contributions to a Roth IRA are made with after-tax money, so you can’t deduct them from your taxes. But your earnings and withdrawals are tax-free.
SEP IRA contributions are typically set up by a small business or someone who’s self-employed. They allow contributions to a traditional IRA set up in the employee’s name.
SIMPLE (Savings Incentive Match Plan for Employees) IRAs are available for small businesses that don’t have any other type of retirement plan for workers. These allow employer and employee contributions that are similar to a 401(k) plan, but they are simpler and less costly to administer. They also have lower contribution limits.
Side-by-Side Comparison of Different IRA Types
IRA Type Who Can Set up This Type of IRA? Employee Contribution Limits (2020) Are Contributions Tax-Deductible? Are Distributions or Withdrawals Tax-Free?
Traditional IRA Individuals and married couples $6,000 if you are younger than 50; $7,000 if you are 50 or older Yes, If you qualify No
Roth IRA Individuals and married couples $6,000 if you are younger than 50; $7,000 if you are 50 or older No Yes
SEP IRA Small business owners and self-employed people Either 25 percent of income or $57,000, whichever is less Yes, but with the amount limited by law No
SIMPLE IRA Small business owners and self-employed people $13,500 if you are younger than 50; $16,500 if you are 50 or older Yes No

Why Should You Invest in an IRA?

Even if you already have a 401(k) or other employer-backed retirement plan, you can still set up an IRA, giving you another source of retirement income.

You may also want to invest up to the maximum amount each year to maximize your potential retirement savings. Talking to a licensed financial professional can help you understand what amount of contributions works best for your financial situation.

One of the biggest benefits of an IRA is that it allows you to invest while deferring taxes on the income you contribute until you withdraw the money. But you are only allowed to contribute certain types of income under the law.

Taxable Earned Income That Can Be Used for IRA Contributions
  • Disability retirement benefits received before minimum retirement age
  • Nontaxable combat pay
  • Salaries
  • Self-employment earnings if you are a contractor meeting certain legal qualifications
  • Self-employment earnings if you are a minister or member of a religious order
  • Self-employment earnings if you own or operate a business or farm
  • Tips
  • Union strike benefits
  • Wages
  • Other taxable employment income

You can only invest earned income into an IRA. Under federal rules, you can’t use income sources that the IRS does not consider taxable earned income.

Types of Income You Cannot Use to Make IRA Contributions
Last Modified: February 12, 2021

10 Cited Research Articles

  1. U.S. Internal Revenue Service. (2020, July 31). What is Earned Income? Retrieved from https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/earned-income
  2. Ortiz, H. and Scheithe, E. (2020, June 30). Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know. Retrieved from https://www.consumerfinance.gov/about-us/blog/cares-act-early-retirement-withdrawal/
  3. U.S. Internal Revenue Service. (2020, January 28). Traditional and Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-and-roth-iras
  4. U.S. Internal Revenue Service. (2020, January 15). Traditional IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-iras
  5. U.S. Internal Revenue Service. (2020, January 10). Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/roth-iras
  6. U.S. Internal Revenue Service. (2020, January 9). Individual Retirement Arrangements (IRAs). Retrieved from https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
  7. U.S. Internal Revenue Service. (2019, December 20). IRA Deduction Limits. Retrieved from https://www.irs.gov/retirement-plans/ira-deduction-limits
  8. U.S. Securities and Exchange Commission. (n.d.). Individual Retirement Accounts. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/self-directed-plans-individual-retirement-accounts-iras
  9. Cornell Law School. (n.d.). 26 U.S. Code Section 408 - Individual Retirement Accounts. Retrieved from https://www.law.cornell.edu/uscode/text/26/408
  10. CNN Money. (n.d.). What Is an IRA? Retrieved from https://money.cnn.com/retirement/guide/IRA_Basics.moneymag/index.htm