What Is an IRA and How Does It Work?

Jennifer Wills
5 days ago
4 min read

I opened my first Individual Retirement Account (IRA) in my 20s. I plan to open additional types of IRAs for retirement planning as my businesses grow.

What an IRA Is

An IRA is a tax-advantaged investment account used to save money for retirement. The type of IRA determines whether the contributions grow on a tax-free or tax-deferred basis.

An IRA is attractive to individuals who do not have access to a 401(k) or other employer-sponsored retirement plan. However, anyone with earned income is eligible to open an IRA.

How an IRA Works

IRA contributions are invested in stocks, bonds, mutual funds, exchange-traded funds (ETFs), or other assets. The individual can choose their investments or have a financial professional select them. The account balance growth depends on the amount contributed, how the money is invested, and the duration of time. Taxes and penalties can be assessed for early withdrawal.

Benefits of IRAs

The benefits of having at least one type of IRA include:

Diverse investment options to support financial goals, risk tolerance, and tax savings.
Potentially receiving a tax deduction on contributions in the year they are made.
Money grows tax-free or tax-deferred.
Retirement distributions could be tax-free.

Types of IRAs

There are four popular types of IRAs:

1. Traditional IRA

Whether contributions to a traditional IRA are tax-deductible in the year they are made depends on the following factors:

Individual’s income level
Tax filing status
Whether the individual or their spouse is covered by a retirement plan at work

A traditional IRA is subject to required minimum distributions if the individual reaches age 72 after December 31, 2022:

The IRS uses the account size and the individual’s life expectancy to determine the amount of money that must be withdrawn annually.
If the distribution is not taken, the individual receives a penalty of 10-25% of the amount not withdrawn.
Withdrawals during retirement are taxed as ordinary income.

2. Roth IRA

Contributions to a Roth IRA are not tax-deductible. However, contributions can be withdrawn tax-free and penalty-free at any time.

Money in a Roth IRA grows tax-deferred and can be withdrawn tax-free in retirement. Since there is no required minimum distribution or penalty for not withdrawing money, the funds can remain in the account for as long as desired.

3. SEP IRA

A Simplified Employee Pension (SEP) IRA generally is for self-employed individuals or small business owners with few or no employees. The contributions are tax-deductible, and the money grows tax-deferred until retirement, when the distributions are taxed as income.

A SEP IRA is subject to required minimum distributions if the individual reaches age 72 after December 31, 2022:

The IRS uses the account size and the individual’s life expectancy to determine the amount of money that must be withdrawn annually.
If the distribution is not taken, the individual receives a penalty of 10-25% of the amount not withdrawn.
Withdrawals during retirement are taxed as ordinary income.

4. SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is for small businesses with fewer than 100 employees. The contributions are tax-deductible, and the investments grow tax-deferred until retirement, when the distributions are taxed as income.

A SIMPLE IRA is subject to required minimum distributions if the individual reaches age 72 after December 31, 2022:

The IRS uses the account size and the individual’s life expectancy to determine the amount of money that must be withdrawn annually.
If the distribution is not taken, the individual receives a penalty of 10-25% of the amount not withdrawn.
Withdrawals during retirement are taxed as ordinary income.

IRA Penalties for Early Withdrawal

Because IRAs are designed to invest money and maximize growth for retirement savings, taxes and penalties could be assessed for early withdrawal:

Traditional IRA

Because Traditional IRA contributions are made using pre-tax dollars, withdrawals are subject to income tax. Withdrawing funds before age 59 ½ typically incurs a 10% penalty on the distribution amount.

Roth IRA

Withdrawals from a Roth IRA that fit the following criteria are tax-free and penalty-free:

Made at least 5 years since the first contribution
Taken because the individual has a permanent disability
Used to buy, build, or rebuild a home that meets the first-time homebuyer exception
Made when the individual is 59 ½ or older
Taken by a beneficiary or the estate after the individual passes away

Withdrawals from a Roth IRA that do not meet these guidelines are subject to income taxes on the earnings and a 10% penalty.

Although individuals who make early withdrawals from a Roth IRA will owe taxes, they might avoid the 10% penalty under certain criteria:

Making a series of substantially equal distributions
Covering unreimbursed medical expenses that exceed 10% of the individual’s adjusted gross income (AGI)
Paying medical insurance premiums after losing a job
Removing an IRS levy
Taking qualified reservist distributions
Covering qualified higher education expenses

IRA Contribution Limits

The IRS sets annual IRA contribution limits. Although the limits are low and typically not enough to fund retirement on their own, they can increase tax savings and complement other retirement savings.

The contribution limits for 2025 depend on the type of IRA:

Traditional and Roth IRAs

Individuals up to age 49 can contribute up to $7,000.
Individuals 50 and older can contribute up to $8,000.
If an individual or their spouse has a retirement plan at work, such as a 401(k), their ability to deduct traditional IRA contributions could be reduced or eliminated.
At specific higher incomes, the maximum Roth IRA contribution phases down until it is eliminated.

SEP IRA

Contributions are limited to 25% of compensation or $70,000.
There is no catch-up contribution at age 50 or older.
If business owners contribute for themselves, proportional contributions are required for each eligible employee.

SIMPLE IRA

The employee contribution limit is $16,500.
Most employees age 50 or older have a catch-up contribution of $3,500.
Employees aged 60 to 63 have a higher catch-up amount.
Employees in certain plans have higher overall and catch-up limits.

How to Open a Traditional or Roth IRA

Individuals with earned income can open a traditional or Roth IRA through an institution approved by the IRS to offer these accounts:

Federally insured credit union
Savings and loan association
Bank
Brokerage firm

*This information is for educational purposes only.