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What is an IRA, and How Does it Work?

2025-04-25
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An IRA (Individual Retirement Account) is an investment account that offers tax advantages for retirement savings. Investing in an IRA is one of the best ways to prepare for old age, as anyone with earned income can open one.

However, before contributing to an IRA, it’s essential to understand which type is suitable for your situation and learn the rules regarding deductible contributions and penalty-free withdrawals.


What is an IRA?

An IRA stands for Individual Retirement Account. There are several types of IRAs, each allowing you to contribute income with tax benefits to build a retirement nest egg.

Different IRAs have various contribution limits, and some impose income restrictions on contributors. For example, the most commonly used IRAs—Traditional IRA and Roth IRA—have a total contribution limit of $6,000 in 2021 and 2022. However, if you’re 50 or older, you can make catch-up contributions, increasing the limit to $7,000 annually.

IRAs can be opened at various financial institutions, including:

  • Discount online brokers
  • Traditional banks
  • Robo-advisors
  • Investment management companies

Once you’ve contributed, you can purchase any assets allowed by the brokerage, such as stocks, bonds, and mutual funds.


Types of IRAs

Several types of IRAs are available, each functioning slightly differently. Some common types include:

1. Traditional IRA

A Traditional IRA allows you to invest pre-tax income for retirement. Contributions may be tax-deductible, and the money can grow tax-deferred until you withdraw it.

  • You can contribute up to $6,000 in 2021 and 2022 ($7,000 if 50 or older).
  • Anyone can contribute, regardless of income, but deduction eligibility is restricted based on your income and workplace retirement plans.

For example, the deduction starts phasing out at these income levels:

  • $66,000 for single filers ($68,000 in 2022)
  • $105,000 for married joint filers with a workplace retirement plan ($109,000 in 2022)
  • $198,000 for joint filers if one spouse has a workplace plan ($204,000 in 2022)

A Traditional IRA is ideal if you expect your tax rate to be lower in retirement. You can claim tax benefits now and pay lower income tax later when you withdraw funds.


2. Roth IRA

The main difference between a Traditional IRA and a Roth IRA is that Roth IRA contributions are made with after-tax dollars.

  • Contributions are not deductible, but your money grows tax-free, and withdrawals in retirement are also tax-free.
  • The total contribution limit is the same as a Traditional IRA: $6,000 ($7,000 if 50 or older) in 2021 and 2022.
  • However, Roth IRAs have income limits for contributions.

A Roth IRA is beneficial if you expect your tax rate to be higher in retirement. This way, you can withdraw money tax-free later when tax rates may be higher.

Additionally, Roth IRA withdrawals do not count toward the income limit that determines whether Social Security benefits are taxed.


3. SEP IRA

A Simplified Employee Pension IRA (SEP IRA) is designed for small business owners or self-employed individuals.

  • Only employers or self-employed individuals can contribute.
  • The annual contribution limit is 25% of compensation or $61,000 in 2022 ($58,000 in 2021), whichever is lower.
  • There are no income limits for contributions.

A SEP IRA is ideal for self-employed individuals or business owners who want to maximize retirement contributions. However, you must contribute the same percentage to all eligible employees. If you have multiple employees, contributing the maximum amount to your own retirement account could mean significant contributions for employees as well.


4. SIMPLE IRA

Like a SEP IRA, a SIMPLE IRA can be set up by employers and self-employed individuals, but both employers and employees can contribute.

  • Employees can contribute up to $14,000 in 2022 ($13,500 in 2021).
  • Those aged 50 or older can contribute an additional $3,000 catch-up contribution.
  • There are no income limits for contributions.

While a SIMPLE IRA has lower contribution limits than a SEP IRA, it offers more flexibility in how employers structure contributions for employees.


5. Rollover IRA

A Rollover IRA is an IRA used to transfer funds from another retirement account.

For example, if you leave a job with a 401(k), you can roll it over into an IRA.

  • You don’t need a special “rollover IRA” account—funds can be moved into an existing IRA.
  • However, tax consequences may arise.
  • To avoid taxes, transfer funds into the same type of account (e.g., a Traditional 401(k) → Traditional IRA or Roth 401(k) → Roth IRA).

6. Spousal IRA

A Spousal IRA is a standard IRA funded on behalf of a spouse with little or no earned income.

  • You can use either a Traditional or Roth IRA for a spousal IRA.
  • Contribution limits are the same: $6,000 ($7,000 if 50 or older).

If one spouse doesn’t earn enough to contribute to an IRA, a Spousal IRA allows them to save for retirement through the working spouse’s income.


Benefits of an IRA

An IRA offers several advantages, including:

✔ Choice of investment accounts: You can choose between tax-deferred (Traditional IRA) or tax-free growth (Roth IRA), depending on your preference.

✔ Significant tax benefits:

  • Traditional IRA: Contributions are tax-deductible, reducing your taxable income.
  • Roth IRA: Withdrawals are tax-free in retirement.

✔ No employer required: Unlike 401(k) plans, you can open and manage an IRA yourself, making it a great supplement to workplace retirement savings.

✔ Easy to open: Some employer-sponsored plans (like 401(k)s) require a lot of paperwork, but IRAs can be opened quickly at a bank, brokerage, or robo-advisor.

✔ More investment flexibility: Unlike 401(k) plans, which limit investment choices, IRAs allow you to invest in stocks, bonds, ETFs, and mutual funds.

✔ Low fees and no minimum balance: Many institutions offer IRAs with no account maintenance fees or minimum balances, making them accessible for most people.

✔ Ability to borrow money: While direct loans from an IRA are not allowed, you can access funds through certain rollover rules.


Conclusion

IRAs offer a powerful tool for retirement savings, providing tax advantages and investment flexibility. Whether you choose a Traditional IRA, Roth IRA, SEP IRA, or SIMPLE IRA, selecting the right account depends on your income, tax situation, and long-term financial goals.

Tags: EconomyStrategy

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