How the IRA Works: A Plain-Language Walkthrough

How the IRA Works at a Glance

An Individual Retirement Account (IRA) is a tax-advantaged savings vehicle that lets you set aside money for retirement with specific tax benefits. The way those benefits work depends on the type of IRA you choose, how much you contribute, and when you withdraw the funds.

Types of IRAs and Their Tax Treatment

The two main categories are traditional and Roth IRAs. With a traditional IRA, your contributions may be tax-deductible in the year you make them, and the money grows tax-deferred until you withdraw it in retirement, at which point it is taxed as ordinary income. With a Roth IRA, you contribute after-tax dollars, meaning qualified withdrawals in retirement are tax-free, provided you meet the five-year rule and are at least age 59½.

Contribution Limits and Eligibility

The IRS sets annual contribution limits. For 2024, the limit is $7,000 if you are under age 50, and $8,000 if you are 50 or older, which includes a $1,000 catch-up contribution. Eligibility for a Roth IRA phases out at higher incomes, while traditional IRA deductibility may be limited if you or your spouse are covered by an employer plan.

Key Rules to Know

• Contributions for a given tax year can be made up until the tax filing deadline, typically April 15.
• Early withdrawals before age 59½ generally trigger a 10% penalty on top of income tax, though certain exceptions apply.
• Required Minimum Distributions (RMDs) for traditional IRAs begin at age 73, while Roth IRAs have no RMDs during the original owner's lifetime.

How to Open and Fund an IRA

You can open an IRA through a brokerage, bank, or robo-advisor. Once the account is open, you fund it by transferring cash, and then you choose investments such as stocks, bonds, mutual funds, or ETFs. The account custodian holds the assets and reports your contributions and earnings to the IRS.

Withdrawals and Penalties

For traditional IRAs, withdrawals are taxed as income and are generally subject to the 10% early-withdrawal penalty if taken before age 59½. Roth withdrawals of contributions can be made anytime tax- and penalty-free, and qualified withdrawals of earnings avoid taxes and penalties. Non-qualified Roth earnings withdrawals may be subject to tax and a penalty.