Guide to IRAs: What Are IRAs and How Do They Work?

Individual retirement accounts, or IRAs, are a popular retirement savings tool because of their tax advantages and diverse range of investment options. However, a lack of understanding about how IRAs work may keep many people from taking advantage of their potential benefits.

Here are answers to common questions about how IRAs work—from basic IRA benefits to the nuances of different types of IRAs.

What is an IRA?

An IRA is a tax-advantaged account designed to help you save more money for retirement. Unlike workplace retirement plans, anyone who has earned taxable income during the year can contribute to an IRA. As a result, they can be a powerful way to save for retirement if you're self-employed. However, even if you already have an employer-sponsored retirement plan, an IRA may help you grow your nest egg in a tax-efficient manner.

How do IRAs work?

IRAs operate much like ordinary brokerage accounts. With both accounts, you have the ability to buy and sell a variety of investments like stocks, bonds, mutual funds and exchange-traded funds. However, because these accounts are designated for retirement savings, they come with some significant tax benefits, along with certain restrictions.

For instance, with a few exceptions, you'll be hit with an early-withdrawal penalty if you take money out too soon. Likewise, you can't contribute beyond the annual limits set by the IRS. The upside, however, is that you'll enjoy tax-deferred growth or tax-free withdrawals, depending on the type of IRA you choose. These potential tax advantages are one of the biggest IRA benefits for many individuals.

What are the different types of IRAs?

There are two main types of accounts to choose from: traditional IRAs and Roth IRAs. The most significant difference between the two options is when you receive a tax break.

• Traditional IRAs are tax-deferred. Within some limits, you'll be able to deduct contributions to a traditional IRA on your annual tax return. However, you'll pay taxes when it's time to take withdrawals.
• Roth IRAs work in reverse. You'll make contributions with after-tax dollars, but your earnings will grow tax-free and you can take tax-free withdrawals in retirement.

Traditional and Roth IRAs aren't the only options, though. There are a few more to consider.

• Rollover IRAs offer the ability to move funds from a qualified employer-sponsored retirement plan into an IRA. They're often a good solution for those wondering what to do with an old 401(k).
• Simplified Employee Pension IRAs, or SEP IRAs, are a type of traditional IRA for both self-employed people and small business owners. With a SEP IRA, employers can contribute up to 25% of each employee's compensation, up to a maximum of $69,000 in 2024.
• Savings Incentive Match Plan for Employees IRAs, or SIMPLE IRAs, are designed for employers with 100 employees or less. Employees can contribute up to $16,000 in 2024—and in some cases $19,500 if they're 50 or older—and employers must either match employee contributions up to 3% or contribute 2% of each employee's compensation.

Is a Roth or traditional IRA better?

Both traditional and Roth IRAs can offer significant benefits, but the right option for you will ultimately depend on your current financial situation and predictions about your future tax rate.

For example, a traditional IRA may make sense if you expect to be in a lower tax bracket in retirement. You'll get an upfront tax deduction on your retirement contributions, which is most valuable when your tax rate is high. Once you reach retirement, you'll pay taxes on withdrawals at the lower rate.

On the other hand, if you expect your tax rate to be higher in retirement than it is now—or if you'd prefer not to pay taxes in retirement—a Roth IRA may be the better choice. This is because you pay taxes on Roth contributions at your current rate, then enjoy tax-free withdrawals later.

Of course, there are other factors to consider when choosing an IRA, including eligibility requirements. Learning more about the differences between a Roth IRA and traditional IRA can help you determine which option is the best fit for your needs.

How much can you contribute to an IRA?

For 2024, you can contribute up to $7,000 to an IRA if you're under age 50. If you're 50 or older, you can make an additional $1,000 catch-up contribution for a total of $8,000. These limits will apply across every IRA you own. In other words, if you have multiple accounts, your total contributions can't exceed the annual limit.

There are a few conditions to take into account.

• Eligibility to contribute to a Roth IRA begins to phase out at certain income levels and is prohibited at higher levels. For example, in 2024 you can't contribute to a Roth if your modified adjusted gross income is $161,000 or more for a single tax filer and $240,000 or more if you're married and filing jointly.
• Contributions to a traditional IRA may not be fully tax-deductible if you or your spouse have access to an employer-sponsored retirement plan—even if you don't participate—and your income exceeds IRS thresholds.

Is an IRA a good investment?

Opening an IRA can be an excellent way to invest for retirement, particularly due to the tax advantages these kinds of accounts offer. However, choosing the right IRA investments for your retirement goals and risk tolerance will be key.

To make the most of your IRA, consider these tips.

• Start early to harness the power of compound growth.
• Max out IRA contributions when your budget allows.
• Choose a diverse mix of assets to manage risk.
• Opt for low-cost investments to minimize fees.
• Automate your contributions to stay on track.
• Review and rebalance your portfolio annually.

Remember, investing always involves some level of risk. Your IRA balance will fluctuate with market conditions, and you could lose money. But historically, a well-diversified IRA focused on long-term growth has been a powerful tool for building retirement wealth.

How does an IRA pay out?

Once you reach age 59 1/2, you can begin taking withdrawals from a traditional IRA without any penalty. Before that, you'll be hit with a 10% early withdrawal charge. Regardless of when you take money out of a traditional IRA, you'll owe income tax on your withdrawals at your current tax bracket. What's more, starting at age 73 or age 75 you must also take required minimum distributions, or RMDs, from your traditional IRA each year in an amount based on your account balance and life expectancy.

Roth IRAs work a bit differently. You can withdraw your original contributions at any time, for any reason, without taxes or penalties. And if you're age 59 1/2 and have held your account for at least 5 years, you can also withdraw your earnings tax-free and penalty-free. Roth IRAs aren't subject to RMDs.

Beyond these basic guidelines, there are many nuances to taking IRA distributions—including exceptions to the early-withdrawal penalty and strategies for minimizing your tax liability. Be sure to understand all the rules before tapping into your IRA.

How do you open an IRA?

The process of setting up an IRA account is relatively easy. However, you'll need to make a few important decisions—starting with choosing an IRA provider. Common options include banks, brokerages, investment companies and robo-advisors.

While your selection will ultimately depend on your needs and preferences, be sure to consider factors like:

• Fees—such as monthly account fees and trading commissions
• Account minimums
• Range of investment options
• Options for self-directed versus managed investing
• Availability of guidance and support
• Ease of use, especially if you plan to manage your own investments

As you open your IRA, there are additional factors you'll need to consider, such as how hands on you'd like to be.

Can you manage your own IRA?

The short answer is yes. With a self-directed investing platform, you can choose your IRA investments and manage your account on your own. This approach offers maximum flexibility and control, but it also means you're responsible for thoroughly researching investments and maintaining your portfolio over time.

You can also opt for a managed IRA. With this arrangement, you'll pay a fee to have professional advisors guide the investment selection and handle ongoing account management. Managed IRAs may be a good choice if you prefer a hands-off approach or want access to more sophisticated investment strategies.

Another alternative may be a robo-advisor. These automated IRAs leverage technology to offer generalized investment advice. As a result, they typically have lower fees than a fully managed IRA.

Another more hands-off approach is to invest in target-date retirement funds. These mutual funds give you a diversified long-term investment portfolio that gradually shifts into more conservative allocations as you age and retirement approaches.

What should you do with an inherited IRA?

The rules for inherited IRAs depend on your relationship to the original account owner. Spouses have the most flexibility—they can take ownership of the IRA and treat it as their own, roll it into another retirement account or take distributions as a beneficiary.

Non-spouses, on the other hand, are subject to vastly different rules. Generally, beneficiaries must liquidate inherited accounts within 10 years, unless they qualify for an exception such as being a minor child of the original IRA owner or being no more than 10 years younger. Having a long-term disability or chronic illness may qualify someone for an exception as well. Still, there are a few nuances to keep in mind. For example, once a child of an IRA owner turns 21, they must follow the 10-year rule.

No matter your situation, it's wise to consult a tax or financial advisor after inheriting an IRA. These accounts come with unique restrictions and tax implications that can be tricky to navigate on your own.

The bottom line

IRAs are a cornerstone of retirement planning for millions of Americans—and for good reason. By offering valuable tax benefits and a diverse range of investment options, these accounts can be a powerful tool for building long-term wealth.

Of course, as with any strategy for retirement savings, careful planning and diligent saving are key to success. If you're unsure where to begin, a financial advisor can help you create a plan that's tailored to your personal financial situation, risk tolerance and long-term objectives.