Individual Retirement Account (IRA): What It Is, 4 Types

What Is an IRA?

An individual retirement account (IRA)—known as an individual retirement arrangement by the IRS—is a long-term, tax-advantaged savings account that individuals with earned income can use to save for the future.

The IRA is designed primarily for self-employed people who do not have access to workplace retirement accounts such as the 401(k), which is available only through employers. However, you can also have an IRA even if you already have a retirement plan at work.

You can open an IRA through a bank, an investment company, an online brokerage, or a personal broker.

How Does an IRA Work?

Anyone with earned income can open and contribute to an IRA, including those who have a 401(k) account through an employer. The only limitation is on the total that you can contribute to your retirement accounts in a single year.

The best IRA accounts will offer the ability to invest in a wide range of financial products, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds.

There are also self-directed IRAs (SDIRAs) that permit investors to make all the investing decisions. SDIRAs offer access to a broader selection of investments, including real estate and commodities. Only the riskiest investments are off-limits.

There are several kinds of IRAs, each with different rules regarding eligibility, taxation, and withdrawals. These types include:

• Traditional IRAs
• Roth IRAs
• Simplified Employee Pension (SEP) IRAs
• Savings Incentive Match Plan for Employees (SIMPLE) IRAs

Individual taxpayers can establish traditional and Roth IRAs. 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 Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerages, federally insured credit unions, and savings and loan associations.

Because IRAs are meant to be used to invest and maximize the growth of funds for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59½. That's in addition to taxes you'd pay on the withdrawn amount.

However, there are some notable exceptions to the penalty rule—withdrawals for educational expenses and first-time home purchases, among others.

A Roth account is funded with post-tax money, so no further taxes are due when the money is withdrawn.

What Are the Different Types of IRAs and Their Rules?

The following is a breakdown of the various types of IRAs and the rules regarding each one.

Traditional IRA

In most cases, contributions to traditional IRAs are tax deductible. So, if you put $4,000 into an IRA, your taxable income for the year decreases by that amount.

In a traditional IRA, your money grows tax-deferred. When you withdraw it after retiring, it is taxed at your ordinary income tax rate for that year.

Contribution Limits

For 2024 and 2025, the maximum annual individual contribution is $7,000. The catch-up contribution continues to be $1,000 for those 50 and over.

If you don’t have a retirement plan at work, your traditional IRA contributions are fully deductible. But if you (or your spouse, if you are married) have a retirement plan at work, such as a 401(k) or 403(b), your modified adjusted gross income (MAGI) determines whether and how much of your traditional IRA contributions can be deducted.

If You Have a Retirement Plan at Work

For 2024, if you are single or file as head of household and have a retirement plan at work, your traditional IRA contributions are fully deductible if your MAGI is below $77,000 ($79,000 for 2025).

If you are married and filing jointly, your traditional IRA contributions are fully deductible if your MAGI is below $123,000 in 2024 ($126,000 in 2025). From there, the deductibility of your contributions starts to phase out as your MAGI increases.

For 2024, the income range that phases out the deductibility of traditional IRA contributions for married couples is $123,000 to $143,000. For 2025, it's $126,000 to $146,000.

For single taxpayers or heads of households, the phase-out range for 2024 is $77,000 to $87,000. For 2025, it is $79,000 to $89,000.

If You Don't Have a Plan at Work but Your Spouse Does

If you contribute to an IRA and aren't covered by a workplace plan but are married to someone who is, the income phase-out range in 2024 is $230,000 to $240,000 ($236,000 to $246,000 for 2025).

Use this chart to see how much of your contribution may be deductible.

Roth IRA

Roth IRA contributions are not tax-deductible in the year in which you make them. But the distributions are tax-free. That means you contribute to a Roth IRA using after-tax dollars and pay no taxes, even on your investment gains.

Also, Roth IRAs do not have required minimum distributions (RMDs). If you don’t need the money, you don’t have to take it out of your account (where it continues growing tax-free). You can contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.

Roth IRA contribution limits for the 2024 and 2025 tax years are the same as they are for traditional IRAs. However, there is a catch: There are income limitations on contributions to a Roth IRA.

The phase-out range for single filers is $146,000 to $161,000 for 2024 ($150,000 to $165,000 for 2025). For married couples filing joint returns, the phase-out range is $230,000 to $240,000 in 2024 ($236,000 to $246,000 in 2025).

SEP IRA

Self-employed individuals such as independent contractors, freelancers, and small-business owners can set up SEP IRAs.

A SEP IRA adheres to the same tax rules for withdrawals as a traditional IRA. For 2024, SEP IRA contributions are limited to 25% of compensation or $69,000, whichever is less. In 2025, you can still contribute up to 25% of compensation, but the limit is $70,000.

Business owners who set up SEP IRAs for their employees are able to deduct the contributions that they make on behalf of employees. However, the employees cannot contribute to their own accounts, and the IRS taxes their withdrawals as income.

SIMPLE IRA

The SIMPLE IRA is also intended for small businesses and self-employed individuals. This type of IRA follows the same tax 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.

The SIMPLE IRA employee contribution limit is $16,000 (or $16,500 for 2025), and the maximum catch-up amount is $3,500.

Required Minimum Distributions (RMDs)

Required minimum distributions (RMDs) are withdrawals that owners of traditional IRA and 401(k) accounts must take every year after they reach a certain age. The age has been revised upwards a couple of times. As of Jan. 1, 2023, an account holder must begin taking money out in the year they turn age 73. That age rises to 75 in 2033.

The amount a person must withdraw is based on the account size and the person's life expectancy. The IRS has a worksheet to calculate the amount.

Failure to take the minimum triggers a severe tax penalty, which is 25% of the balance of the account. That's half the previous penalty but still expensive enough to keep us on our toes.

However, this penalty can be reduced to 10% in many cases if the taxpayer takes corrective action early.

Comparing IRA Options

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

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

The Bottom Line

IRAs are retirement savings accounts that offer tax advantages. They work a bit like a 401(k) but don’t require an employer to sponsor them. There are several types of IRAs: traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

There are annual income limitations on deducting contributions to traditional IRAs and contributing to Roth IRAs, so there is a limit on how much tax you can avoid by investing in an IRA.

IRAs are meant to be long-term retirement savings accounts. If you take money out early, you defeat that purpose by diminishing your retirement assets. That’s why money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn (in addition to normal taxes owed).