What's an IRA and How Does It Work? Types, Limits and More

IRAs are a tax-advantaged way for almost everyone to save for retirement. Unlike 401(k)s, your eligibility and options don't depend on where you work.

You can open an IRA on your own, keep the same account when you change jobs and move money between IRAs from different providers without losing benefits. It's your individual account, and you get to control it. Let's take a closer look at how IRAs work.

What Is an IRA?

Individual retirement arrangements (IRAs), more commonly known as individual retirement accounts, are a type of tax-advantaged retirement account.

An IRA can be a good option if you're self-employed or don't have access to a retirement plan at work. Some people who have employer-sponsored plans also open and contribute to an IRA because they receive similar tax benefits with more control over the account.

You can invest the money in your IRA into different types of assets, including certificates of deposit (CDs), stocks, bonds, mutual funds and exchange-traded funds (ETFs). In traditional IRAs, you get tax-deferred growth—meaning you don't pay taxes on your earnings until you withdraw the money in retirement. This tax deferral can boost long-term returns because your investment gains can compound without being reduced by annual taxes.

However, IRAs are intended for retirement savings. You may have to pay penalties if you withdraw money before you turn 59½ and don't qualify for an exception.

How Does an IRA Work?

The specifics can vary depending on the type of IRA and your tax situation, but here's a general overview of how IRAs work:

• Almost anyone can open an IRA. Unlike with employer-sponsored retirement plans, such as 401(k)s and 403(b)s, you set up an IRA—not your employer—and the money won't necessarily come from your paycheck.
• You can only contribute if you have taxable income. You can only contribute to an IRA if you (or your spouse, if you file jointly) had taxable income during the year. Your contribution limit will be the lower of the IRS's annual limit or your taxable income.
• IRAs are a type of account, not an investment. You can open IRAs at different financial institutions, including banks and brokerages. However, the money you contribute won't necessarily get invested automatically—you'll need to pick your investments. You can even use a self-directed IRA to purchase real estate, invest in private companies and make alternative investments.
• You could have lots of investment choices. Depending on where you open the IRA, you might be able to choose from more investments than you have with a 401(k).
• You can have multiple IRAs. You can open and contribute to different IRAs at the same time, but your annual contribution limit is for the sum of all your contributions.
• You can pay taxes now or later. Traditional and Roth IRAs are two popular types of IRAs. You can often deduct your contributions to traditional IRAs and defer paying income taxes until you withdraw the contributions and earnings later. With a Roth IRA, you don't get a deduction today, but all contributions and earnings could be tax-free when you withdraw them later.
• You can benefit from tax-deferred growth. Traditional and Roth IRAs don't require paying taxes on your earnings each year. The tax-free growth allows you to keep more money in your account and benefit from compound growth.
• IRAs are separate from retirement plans at work. You can have both an employer-sponsored retirement plan and an IRA. Each will have its own annual contribution limit and potential tax benefit.

Types of IRAs

Traditional and Roth IRAs are two of the most common types of IRAs. The main difference is whether you pay income taxes on the money you contribute now or you pay income taxes when you withdraw the money and your earnings later.

Traditional vs. Roth IRA overview

Here's a side-by-side look at some of the key features of traditional and Roth IRAs.

SEP IRAs, SIMPLE IRAs and state-sponsored plans

There are also Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs, which have different rules and higher contribution limits than traditional or Roth IRAs.

Small businesses and self-employed individuals often use these plans if they want to offer retirement benefits without the costs and administrative requirements of a 401(k). SEP IRAs allow employers to make contributions on behalf of employees, including a self-employed business owner, while SIMPLE IRAs allow both employer and employee contributions.

Additionally, some states offer retirement plans for people who are self-employed or work at small businesses. These state-sponsored plans are typically set up as Roth or traditional IRAs, and you may be automatically enrolled in one if you work for a small business that doesn't offer a different retirement plan. Like with employer-sponsored plans, you may be able to easily contribute to your retirement account by having money taken out of each paycheck.

Required Minimum Distributions for IRAs

Traditional IRAs, SEP IRAs, and SIMPLE IRAs—along with some employer-sponsored retirement plans—require you to begin taking distributions from your account after you turn 73 (starting in 2023). The age for required minimum distributions (RMD) will increase to 75 starting in 2033 under the SECURE Act 2.0. The IRS provides formulas for calculating your RMD amount based on your account balance and your life expectancy or distribution period.

You can find these online in IRS Publication 590-B. Understanding and preparing for RMDs is an important part of retirement planning because you may need to choose which investments to sell before withdrawing money.

Roth IRAs don't require distributions, which is why having a mix of retirement savings in traditional and Roth IRAs might be a good idea.

How To Start an IRA in 3 Steps

You can often quickly open an IRA online, similar to how you might open a checking or brokerage account.

1. Decide where to open the account. You can open IRAs at banks, credit unions, brokerages, robo-advisors, mutual fund companies and other financial institutions. Compare the requirements, fees and investment options to determine which is the best fit for you.
2. Choose between traditional and Roth. Many financial institutions let you choose either a Roth or traditional IRA. A general rule of thumb is to use a traditional IRA when you're in a high tax bracket and expect to be in a lower bracket after retiring. If you're in a low tax bracket now, a Roth IRA might make more sense.
3. Make your contributions. You can contribute money to your IRA anytime before the tax filing deadline for the year. For example, you can make contributions toward your 2024 limit until April 15, 2025. You'll be asked if your contribution is for 2024 or 2025 if you make it after the new year.

Consider an IRA When Planning for Retirement

Your retirement planning options and goals may change based on your age and stage, but an IRA can be a constant that offers a safe and reliable place to invest for your future. However, you'll need to decide how to invest the money based on how much risk you want to take, how long you have until retirement and your other sources of income after retiring.

You could hire a financial advisor to get expert insights. You can also learn a lot on your own. The Synchrony blog has dozens of retirement planning articles if you're looking for a good place to start.