What Is an IRA, and How Does It Work?

The term “IRA” stands for an individual retirement account, and its purpose is to help you save for retirement. IRAs are widely available at many financial institutions, and they don’t require the presence of an employer like a 401(k) does. However, IRAs share many of the tax benefits of a 401(k), and they come in a few different variations: Roth, traditional and IRA CD. Additionally, the IRS sets annual limits on how much you can contribute to an IRA. Let’s explore how it works and what it can do for you.

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What Is an IRA?

The history of the traditional IRA began in 1975, when the provisions of the 1974 Employee Retirement Income Security Act (ERISA) came into effect. That opened the door for the individual retirement account, through which Americans could start saving for retirement if they didn’t have a pension they could count on.

As the years passed, pensions became less and less common. In their place, there are retirement plans that put the burden of savings on the worker rather than the company. These are called Defined Contribution Plans, and 401(k)s also fit into that category.

With a traditional IRA, you can contribute money from your pre-tax earnings to an account that will grow over time. Each year at tax time, you can deduct some or all of the amount that you contributed from your income, lessening your tax burden. When you start taking distributions from your IRA in retirement, those distributions will be taxed as income. A Roth IRA works oppositely, as you fund this type of IRA with after-tax dollars. So in this case, you won’t pay income taxes even in retirement.

Before 2020, the IRS barred anyone who was 70 1/2 or older from making contributions to a traditional IRA. However, now everyone, regardless of their age, can continue funding their IRA.

An IRA distribution is money that you withdraw after you’ve reached 59 1/2. This age also serves as the cut-off for being able to dip into your IRA without incurring a penalty. Calling the money you take from your IRA after age 59 1/2 a distribution may be confusing, but it helps differentiate between that money and a sum of money you take out early. The latter of these is commonly known as a withdrawal.

How Much Can I Contribute to My IRA?

The federal government places contribution limits on how much money you can put into your IRA, regardless of what kind of account you open (traditional or Roth). For the 2025 tax year, your IRA contributions cannot exceed $7,000 per year. If your taxable income for the year is less than $7,000, then that will be your cap.

To help people who start saving for retirement late, the IRS offers special catch-up contribution limits. Once you reach 50, you can contribute an extra $1,000 a year, for a total contribution limit of $8,000.

There are only a few ways you can avoid these contribution limits. One is if the money you’re depositing in your IRA is from a 401(k) rollover. Another is if the deposited funds are from qualified reservist payments.

Breaking Down the Different Types of IRAs

All IRAs work similarly as investments, but their tax benefits differ.

While the three main versions of an IRA work essentially the same way from an investment standpoint, there are some differences between them. This is particularly obvious in what types of tax benefits they provide their owners. The best choice for you will depend entirely on your financial situation.

Traditional IRA

A traditional IRA is the most common form of IRA, and it offers many of the same benefits as a standard 401(k). For starters, the money that you deposit in your IRA becomes deductible from your taxable income for the year. In turn, you will hold off paying taxes on those funds. However, there are some rules surrounding the IRA deduction.

Let’s say you have a retirement plan at work. If your tax filing status is single or head of household, then your modified adjusted gross income (MAGI) can be up to $79,000 before your deduction starts shrinking. Once your MAGI reaches $89,000, you’re no longer eligible for a deduction.

For those married and filing jointly, their MAGI can be up to $126,000 before their deduction will start shrinking. If you file married filing separately, though, you’ll only receive a partial deduction if MAGI is up to $10,000 and no deduction for higher incomes.

Once you reach retirement age, the IRS will tax you on the money you withdraw from your traditional IRA. At that time, you’ll pay the normal income tax rate for the bracket your taxable income falls within. If you open a traditional IRA, you will need to start taking required minimum distributions (RMDs) once you turn 70 1/2 years old. However, if your 70th birthday comes after July 1, 2019, RMDs don’t start until age 72.

Do you need help figuring out your required minimum distributions? Try SmartAsset’s RMD calculator to learn more.

Roth IRA

Unlike a traditional IRA, a Roth IRA lets you save with after-tax dollars. That means you won’t reduce your taxable income now, but you’ll get tax benefits down the road. When you withdraw money from a Roth IRA in retirement, you don’t have to pay taxes on those distributions. This is true regardless of whether you pull from your principal or capital gains from your investments. Roth IRA account holders are also not subject to RMD rules.

Roth IRAs follow the same contribution limits as traditional IRAs. On the other hand, there are income limits for who can contribute to a Roth IRA. In 2025, single filers and heads of household with up to $150,000 in MAGI can contribute up to the maximum. If you’re married and filing jointly with a MAGI up to $236,000 you can also contribute without restriction.

For those married but filing separately, limits will depend on whether you lived with your spouse during the tax year or not. Couples who lived together receive a reduced contribution limit if their MAGI is $10,000 or less. Couples who did not live together can contribute up to the maximum if their MAGI is no higher than $150,000.

If you think your tax bracket is lower now than it will be in retirement, a Roth IRA could be a good option for retirement savings, since you won’t have to pay taxes later In addition, the younger you are, the more you stand to gain from opening a Roth since you’ll accrue more tax-free earnings on your contributions. There are also no RMDs with a Roth IRA, which can be an advantage for someone planning to leave an inheritance to future generations.

IRA CD

An IRA CD is simply a certificate of deposit (CD) that you hold in your IRA. So, instead of investing all of your IRA funds in stocks and bonds, you buy one or more CDs. The pros and cons of an IRA CD are the same as those of a regular CD that you buy at any bank.

With a CD, you typically earn a lower interest rate than you would if you invested your money in stocks over the long term. On the other hand, your money won’t disappear like it could if you invested in stocks. That’s why some people use CDs as a way to keep semi-liquid funds for emergency use or to hedge against riskier investments.

IRAs vs. 401(k)s

IRAs and 401(k)s are perhaps the two most popular retirement accounts available today. While an IRA is something you open on your own accord, a 401(k) comes to you through an employer. There’s nothing forbidding you from having both accounts at once, though.

One of the biggest benefits a 401(k) has over an IRA is that an employer can match your contributions. This essentially equals a bonus to what you’re already contributing. Employers often limit how much they’ll match, with caps usually taking the form of a percentage of your salary. For instance, your employer may match 100% of your contributions, up to 3% of your annual salary.

Although the tax benefits are enticing, RMDs come into play for both traditional IRAs and 401(k)s. But if you open a Roth IRA, you won’t need to adhere to any RMD rules. This is a huge perk, as it means the federal government won’t force your hand in retirement. Note that if you pass on your Roth IRA to a beneficiary, they will need to take RMDs.

When it comes to investments, IRAs typically provide much more plentiful opportunities. That’s because they’re often available directly through brokerages that have a wide range of investments. A 401(k), on the other hand, usually offers a handful of potential investments, with choices revolving around target-date funds. But if you prefer a more hands-off approach, that may not be a big deal to you.

How to Open an IRA

When choosing an IRA, compare providers carefully, since fees can reduce your long-term retirement growth.

If you’re shopping for an IRA, you have plenty of options. Many of the big names in finance offer IRAs and compete with each other to offer lower fees. Any charges you incur will eat directly into your retirement savings, leaving you with less money to compound over time. Vanguard is a popular choice for its low fees, but there are other options too.

Once you find an IRA provider whose fees and account terms fit your needs, it’s a pretty simple process. There are a few main steps to opening your own IRA:

Go to your IRA provider’s website or visit a branch location if it offers them. Here, you’ll need to fill out some paperwork and list your name, address, employer, other retirement accounts, Social Security number and more.
Initiate the funding of your account by transferring money from your bank account. You can also roll over a 401(k) into an IRA, but if you do this, make sure to ask your IRA provider for help. An improper 401(k) rollover can leave you on the hook for early withdrawal penalties.
Once your account is open and funded, decide on your portfolio’s asset allocation. This means choosing how much risk you’re willing to take on and adhering to that plan. For example, a riskier investor might invest in a 70/30 stock to bond split, whereas a safer investor will stick to mostly cash and bonds. Once you make your decisions, you can begin investing.

Opening an IRA CD involves the same steps as opening a savings account at a bank. Simply choose the bank or credit union that you want to open your IRA CD, pick a term and deposit your money. Note that like a normal CD, the longer the rate you select, the better your APY will usually be.

Tax Treatment of IRA Withdrawals

When you begin taking money out of your IRA, the IRS treats those withdrawals differently depending on the type of account. With a traditional IRA, the funds you take out are taxed as ordinary income because your contributions were made with pre-tax dollars. That means withdrawals are added to your taxable income for the year and taxed according to your income bracket.

A Roth IRA works the opposite way. Since contributions were made with after-tax dollars, withdrawals are not taxed if you follow the rules. This means both your contributions and any investment earnings can come out tax free in retirement. However, the Roth IRA must have been open for at least five years, and you must be 59½ or older to avoid taxes and penalties.

If you take money from a traditional IRA before reaching age 59½, you may face a 10% early withdrawal penalty on top of regular taxes. There are some exceptions, such as paying qualified education expenses, buying your first home, or covering certain medical costs, but most early withdrawals will reduce your savings through taxes and penalties. You can generally withdraw money you contributed to a Roth IRA at any time, tax- and penalty-free. Withdrawing investment gains before age 59½, however, will trigger penalties and taxes, except in certain situations.

Once you reach a certain age, traditional IRAs also require minimum distributions, which are mandatory withdrawals set by the IRS. These distributions ensure that taxes are eventually collected on the funds. Roth IRAs do not require minimum distributions during the account owner’s lifetime, which allows them to keep growing tax free or be passed on to heirs.

The way withdrawals are taxed has a direct impact on your retirement income. Planning when and how to draw from your IRA can help reduce your overall tax bill. Many retirees coordinate withdrawals with Social Security, pensions, or other income sources to manage their tax brackets more effectively.

Bottom Line

Saving money in an IRA can be a strong way to prepare for a financially secure retirement while lowering your tax bill. Your tax benefits depend on the type of IRA you choose. IRAs often offer more flexibility than a 401(k), but the two can work together effectively. Be sure to follow IRS rules on contribution limits, especially if you are under age 50.

“There’s a place for both traditional and Roth IRAs in your retirement savings plan, but the Roth version is a great starting point if you fall under the income limits and you think your income will increase in the future,” said Tanza Loudenback, a Certified Financial Planner™ (CFP®). “Make use of a Roth IRA while you can to build up a pot of tax-free income for retirement, or for passing down to your heirs.”

Tanza Loudenback provided the quote(s) used in this article. Please note that Tanza is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinions voiced in the quote(s) are for general information only and are not intended to provide specific advice or recommendations.

Retirement Planning Tips

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