What Is An IRA? Types And How They Work

An IRA is a tax-advantaged investment account that you can use to save for retirement. Technically, IRA stands for Individual Retirement Arrangement, but the ‘A’ in the acronym is colloquially referred to as an account.

IRAs are particularly valuable tools for the 33 percent of private industry workers in the U.S. who do not have access to a workplace-based retirement plan such as a 401(k) plan. Too often, that lack of a 401(k) from an employer means that people don’t save for retirement, but IRAs give all workers a convenient way to prepare for their golden years.

It’s important to note that IRAs can also be ideal for the 67 percent of people who do have access to a workplace-based plan. If you’re maxing out your contributions there or you simply want another option with more control over your investments, an IRA can present a great way to save even more money for retirement.

How does an IRA work?

Using an IRA versus a regular taxable brokerage account for retirement feels similar to the difference between speeding through the E-Z Pass lane on the highway or stopping at the toll booth every 20 miles: You’re going to get where you want to go a bit faster without having to stop at the tax tollbooth every year as you would with a regular brokerage account.

When you open an IRA, you contribute funds that can then be invested in a wide range of assets — CDs, stocks, bonds and other top investments. You’re not limited to a menu of investments as you often are in a 401(k). That means you can take full control of how to invest this account.

If you don’t feel well-equipped to choose investments for your IRA, it’s wise to browse robo-advisors or pick a target-date retirement fund. Both are low-cost ways to get broad-based diversification tailored to your time horizon and your risk tolerance.

No matter when you’re hoping to retire, today’s asset allocation — how you split your money between stocks, bonds and other investments — is absolutely critical to tomorrow’s earnings. In fact, some studies have shown that asset allocation determines as much as 90 percent of an investor’s total return. IRAs offer flexibility in adjusting those investments, too. You can move in and out of them — for example, shifting your money from individual stocks to bonds — without incurring capital gains taxes.

While you can move the money around freely within the IRA, you may not be able to take it out early without costs. An IRA is designed for retirement, which means that withdrawals from a traditional IRA before you are 59 1/2 will incur both taxes and a hefty penalty of 10 percent — unless you’re using the money for special exceptions such as buying your first home or paying for higher education (and those exceptions come with caveats).

Types of IRAs

IRAs come in several flavors. The fundamental differences between them are whether you pay taxes before contributing or after withdrawing funds, and when you are required to withdraw funds.

Traditional IRA

With a traditional IRA, you could be eligible to receive a tax deduction in the year you make the contribution. Your contribution is capped at $7,000 in 2025, or $8,000 if you’re age 50 or older). When you withdraw the funds later, you’ll pay taxes on the full amount you are withdrawing. Once you turn 73, you must start making withdrawals.

Roth IRA

A Roth IRA doesn’t offer the instant gratification of an immediate tax break. Instead, you’ll pay taxes on your income now, contribute it to a Roth IRA and avoid taxes when you withdraw the proceeds in retirement. However, there is no requirement to make withdrawals from a Roth IRA. The Roth IRA contribution limits are the same as they are for traditional IRAs: $7,000 in 2025, or $8,000 if you’re age 50 or older.

As a rule of thumb, many financial advisors say a traditional IRA is better when you’re in a higher tax bracket than a Roth IRA is. When comparing traditional and Roth IRAs, it’s fairly common to think about current tax status versus your tax status in retirement, with the assumption that you’ll be in a lower tax bracket when you are no longer working.

However, it’s recommended you avoid that debate. Why? Because it’s very difficult to predict your tax bracket 30 years from today. Instead, look at the choice of a Roth from the perspective of diversifying your tax exposure and giving that money even more time to grow and compound without the headwind of taxes. Regardless of your future tax bracket, having some assets accumulated in a Roth IRA that can later be withdrawn tax-free is worth considering.

SEP IRA

A SEP IRA is an account that’s available to the self-employed or business owners. It offers the tax advantages of an IRA, and the employer can contribute the lesser of 25 percent of income or $70,000 in 2025 — much more than what workers alone can set aside in a regular IRA.

SIMPLE IRA

A SIMPLE IRA is another type of employer-sponsored retirement plan for the self-employed or business owners. Employees can defer their salary to their account, and employers must contribute to the account. The contribution limit for employees is $16,500 in 2025. However, employees of a company with fewer than 25 employees enjoy a contribution limit that is 10 percent higher, though larger employers may also offer this higher limit in some circumstances.

If your plan allows it, employees aged 50 and older can make catch-up contributions of up to $3,500. However, employees may be able to contribute larger catch-up contributions under some conditions, such as if they are age 60-63. 

How to open an IRA

To open an IRA, you or your spouse need to have earned income from working. If that’s the case, you can follow these steps: 

1. Choose your type of IRA. Based on the information above regarding traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs, choose the option that makes sense for you. 
2. Find a brokerage. You can open an IRA at a wide range of places including brokerage firms, mutual fund companies, banks and credit unions. Pay attention to management fees, commissions and minimum opening requirements to make sure you find a good deal.
3. Offer your personal details. Like when you open, you’ll need to share information such as your Social Security number and contact information. 
4. Fund the account. The ways you’re able to fund your account will vary by platform, but you can likely connect a bank account and transfer funds directly to the retirement account.

And in addition to the basic terms of each IRA, compare educational resources if you plan on being in the driver’s seat making your own investing decisions. Some firms offer robust tools to help you understand the market and make wise choices.

Pros and cons of an IRA

IRAs have plenty of pros, including: 

• Tax benefits: IRAs offer tax-free growth of your money. Traditional IRAs also come with tax deductions for your contributions. 
• Flexibility: When you invest via a 401(k), you are limited to the investments the plan offers. But with IRAs, you have more control over the stocks, bonds and funds that your money goes toward. 
• No RMDs for some IRAs: Roth IRAs don’t come with required minimum distributions (RMDs).

But they also have drawbacks, including: 

• Low annual contribution limits: Both IRAs and Roth IRAs have strict contribution limits that may prohibit you from contributing the full amount or at all.
• Early withdrawal penalties: Depending on the type of IRA, you may face penalties if you withdraw your money before age 59 ½.
• Potential for RMDs: Traditional IRA rules require that you start withdrawing your money once you hit age 73.

Is it better to have a 401(k) or an IRA?

Both a 401(k) and IRA offer key advantages for those looking to save for retirement. But when it comes down to it, a 401(k) is better than an IRA for several reasons, in particular because of higher contribution limits and the ability to receive a company match, which is like free money.

A 401(k) allows workers to save up to $23,500 for 2025 compared to just $7,000 in an IRA. And it does better for catch-up contributions, too. For those 50 and older, the 401(k) lets you contribute an additional $7,500, while the IRA has a more modest $1,000 catch-up limit.

A 401(k) may also come with a company matching contribution, meaning that you’ll receive money from your employer if you add to your account. Typically, you’ll receive 50 to 100 percent of your contribution, up to three to five percent of your salary, depending on your plan. It’s an easy way for you to generate an immediate and risk-free return on your money, and experts routinely advise workers to be sure to get the entire company matching contribution.

IRA FAQs

• How much money do you need to start an IRA?
  

  There is not a standard minimum investment amount needed to open an IRA. Brokerages may implement their own minimum requirements, but often you can begin with as little as $1.

• How does an IRA make money?
  

  Once you open an IRA, you’re then able to invest the money within your account in stocks, bonds and funds. Over time, your money will ideally grow as it would in a traditional brokerage account.

• What is the average return on an IRA?
  

  The average return of an IRA will depend on what you invest in. The stock market’s average annual returns, for example, have typically been around 10 percent over time.

Bottom line

IRAs can be a good way to save for your future, whether you’re also contributing to an employer retirement plan like a 401(k) or not. They come with tax advantages that traditional brokerage accounts don’t, and they tend to offer more flexibility than 401(k)s. However, they also have strict contribution limits and, in some cases, early withdrawal penalties. Be sure to carefully consider which IRAs you’re eligible for — and which best suit your needs — before opening an account.  

— Bankrate’s James Royal, Ph.D., contributed to an update of this story.