What Is an IRA? Definition & Purpose

What Is an IRA? Definition & Purpose

Let me explain what an IRA is: it's a long-term, tax-advantaged savings account that you, as an individual with earned income, can use to save for your future retirement. The IRS calls it an individual retirement arrangement, but it's essentially the same thing.

I designed this primarily for self-employed people who don't have access to workplace plans like a 401(k), which employers provide. But you can still open an IRA even if you have a retirement plan at work.

You can set one up through a bank, investment company, online brokerage, or personal broker.

Key Takeaways

Individual retirement accounts, or IRAs, are retirement savings accounts that come with tax advantages. The types include traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

You usually can't withdraw money from an IRA before age 59½ without facing a 10% tax penalty on the amount taken out. There are annual income limits that affect the deductibility of contributions to traditional IRAs and the ability to contribute to Roth IRAs.

For traditional IRAs, required minimum distributions, or RMDs, must start at age 73.

How Does an IRA Work?

If you have earned income, you can open and contribute to an IRA, even if you already have a 401(k) through your employer. The only limit is the total amount you can put into all your retirement accounts in one year.

The best IRA accounts let you invest in a wide range of options like stocks, bonds, ETFs, and mutual funds. There are also self-directed IRAs where you make all the investment decisions, giving access to things like real estate and commodities—only the riskiest investments are prohibited.

Different IRAs have their own rules on eligibility, taxation, and withdrawals: traditional, Roth, SEP, and SIMPLE. You as an individual can set up traditional or Roth IRAs, while small business owners and self-employed people can establish SEP and SIMPLE IRAs.

You must open an IRA with an IRS-approved institution, such as banks, brokerages, credit unions, or savings and loan associations. Since IRAs are for investing and growing retirement funds, withdrawing early before 59½ usually means a 10% penalty plus taxes on the amount.

There are exceptions to that penalty, like for educational expenses or first-time home purchases. With a Roth IRA, you fund it with post-tax money, so withdrawals are tax-free. Remember, you can only contribute if you have earned income—things like interest, dividends, Social Security, or child support don't count.

IRA Types: Traditional, Roth, SEP, and SIMPLE Compared

Here's a breakdown of the various IRA types and their rules.

Traditional IRA

Contributions to traditional IRAs are usually tax-deductible. For example, if you put $4,000 in, your taxable income drops by that amount. Your money grows tax-deferred, and when you withdraw after retiring, it's taxed at your ordinary income rate for that year.

For 2024 and 2025, the max annual contribution is $7,000, or $8,000 if you're 50 or older. If you don't have a work retirement plan, your contributions are fully deductible. But if you or your spouse do, your MAGI determines deductibility.

If you have a plan at work and are single or head of household, full deductibility applies if your MAGI is below $77,000 for 2024 or $79,000 for 2025. For married filing jointly, it's below $123,000 for 2024 or $126,000 for 2025. Deductibility phases out as MAGI increases.

You can have multiple IRAs, but total contributions can't exceed $7,000 or $8,000 annually.

Roth IRA

Roth IRA contributions aren't deductible in the year you make them, but distributions are tax-free since you use after-tax dollars. There are no RMDs, so you can leave the money growing tax-free if you don't need it, and you can contribute at any age with earned income.

Contribution limits match traditional IRAs, but income limits apply: for 2025, phase-out for singles is $150,000 to $165,000, and for married joint filers, $236,000 to $246,000.

SEP IRA

Self-employed individuals like contractors, freelancers, and small-business owners can set up SEP IRAs. They follow traditional IRA tax rules for withdrawals. For 2024, contributions are up to 25% of compensation or $69,000, whichever is less; for 2025, it's $70,000 max.

Business owners can deduct contributions for employees, but employees can't contribute themselves, and withdrawals are taxed as income.

SIMPLE IRA

SIMPLE IRAs are for small businesses and self-employed, following traditional IRA withdrawal rules. Employees can contribute, and employers must too—all contributions are deductible, potentially lowering taxes.

For 2025, employee limit is $16,500, or $20,000 if 50 or older.

Wash-Sale Rule and IRAs

In 2008, the IRS ruled that IRA transactions can trigger the wash-sale rule. If you sell shares in a non-retirement account and buy identical ones in an IRA within 30 days, you can't claim losses, and the IRA basis doesn't increase.

Required Minimum Distributions (RMDs): When and How They Apply

RMDs are required withdrawals from traditional IRAs and 401(k)s starting at age 73 as of 2023, rising to 75 in 2033. The amount depends on account size and life expectancy—use the IRS worksheet to calculate.

Failing to take it incurs a 25% penalty on the unwithdrawn amount, reducible to 10% with early correction.

Comparing IRA Options

To compare, traditional IRAs allow deductible contributions based on income and have RMDs; Roth offers tax-free distributions without RMDs but with income limits; SEP and SIMPLE are for businesses, with higher limits and employer contributions.

What Does IRA Stand For?

IRA stands for individual retirement arrangement per the IRS, or commonly individual retirement account—a plan for saving with tax benefits.

What Are the Advantages of an IRA?

An IRA reduces your taxes either on contributions or withdrawals, with tax-deferred or tax-free growth. Contributions lower current taxes or eliminate future ones on gains. They're FDIC-insured up to $250,000.

How Can I Start a Roth IRA or Traditional IRA?

Open one at banks, credit unions, or brokers like Fidelity or Schwab by visiting and filling out a form.

When Can I Withdraw From an IRA?

Withdraw after 59½ to avoid the 10% penalty plus taxes; exceptions exist for medical, disabilities, or first homes. Waiting longer lets money grow more.

How Is a 401(k) Different From an IRA?

401(k)s are employer-sponsored with automatic deductions and possible matches, higher limits, but limited investments. IRAs are open to anyone with income, offer more investment choices, but no employer match.

The Bottom Line

IRAs are tax-advantaged retirement accounts like 401(k)s but without needing an employer. Types include traditional, Roth, SEP, and SIMPLE, with income limits on deductions and contributions. Early withdrawals before 59½ incur a 10% penalty plus taxes, so they're for long-term savings.