What Is an IRA?

An IRA is one of the simplest ways to save for retirement. Unlike a 401(k), your employer doesn’t need to offer one—you can open one on your own.

Written by Jacqui Kenyon / February 28, 2022

Quick Bites

  • An IRA, or individual retirement account, allows you to use money you’ve earned to save for retirement, regardless of your work situation.
  • There are two main types of IRAs: traditional and Roth. The biggest difference between them is how contributing to them will affect your tax situation.
  • You can save $6,000 per year (or $7,000 per year if you’re over 50) in an IRA, though there are income limits for contributing to a Roth.
  • It’s good to have a mix of retirement accounts with different tax treatments in your portfolio, because it will give you flexibility when it’s time to make withdrawals once you’re retired.

There are so many demands on our hard-earned dollars, from living expenses to paying off debt to the little treats that let us enjoy our lives in the now. As a result, it can be hard to prioritize saving money for retirement, especially when it’s several decades away.

But the best time to start is now. The sooner you start saving, the longer your money has to compound over time. Compounding is when investment earnings are added to the original balance you contributed, which helps your money grow more quickly.

One of the simplest ways to start investing for your golden years is in an IRA, or individual retirement account, an investment account specifically for retirement. Unlike a 401(k), which must be administered by your employer, you can open an IRA regardless of your work situation as long as you have earned income.

There are two different types of IRAs: traditional and Roth. Each account type has its own rules and limits, but the main difference between them is the tax treatment of the contributions and withdrawals.

When you choose between a traditional IRA and a Roth IRA, you’re essentially choosing whether you’d like to take your tax break now or down the road, once you’re retired (assuming you meet the income limits for deductions).

Inside this article

  1. What’s a traditional IRA?
  2. What’s a Roth IRA?
  3. IRA contributions and limits
  4. Withdrawals
  5. Which to choose?

What’s a traditional IRA?

A traditional IRA allows you to put money you’ve earned toward your retirement savings and deduct the contribution amount from your taxable income (as long as you meet the income requirements). This effectively reduces the amount of money you’re taxed on, which keeps more money in your pocket. You also won’t pay taxes on the investment earnings in the account as your money grows over time.

Tip: Since you don’t pay taxes on the contributions, you’ll have to pay taxes on them when you withdraw the money in retirement. For that reason, a traditional IRA might be right for you if you expect that you’ll be in a lower tax bracket in retirement.

What’s a Roth IRA?

When you contribute to a Roth IRA, you’re using money that you’ve already paid taxes on—so you won’t decrease your taxable income today. But the money grows in the account tax-free, and when you withdraw the money in retirement, you won’t have to pay taxes on it.

Tip: If you think you may be in a higher tax bracket when you retire, a Roth may be the right choice for you.

IRA contributions and limits

There’s an annual limit for contributions to IRAs: $6,000 per year for 2022, or $7,000 if you’re 50 or older.[1] If you make contributions to both a Roth IRA and a traditional IRA, the total amount of your contributions can’t exceed $6,000 or $7,000, depending on your age.

There are also income limits for deductions for both types of IRA.

For traditional IRAs

If you contribute to a traditional IRA, you may not be able to deduct the full dollar amount of your contributions from your taxable income. How much you can deduct will vary depending on your income, your marital status and whether you or your spouse have access to a tax-advantaged retirement plan at work, like a 401(k) or a 403(b).[2]

If you are single:

If you are single and don’t have access to a retirement plan through your employer, you can deduct the full $6,000 from your taxable income.

If you’re married and your spouse does not have a retirement plan at work:

You can also deduct the full $6,000 annual contribution from your taxable income.

If you’re married and your spouse has a retirement plan at work:

If you earn less than $204,000 per year in modified adjusted gross income (AGI), you can take a full deduction. Once you’re earning more than $204,000, the amount you can deduct starts to decrease, and once you’re earning $214,000 or more, you can’t deduct any of your contributions on your taxes. The income limits are significantly lower if you are married but file your taxes separately from your spouse.

Tip: Modified adjusted gross income (MAGI) is your adjusted gross income (AGI) plus specific types of income and other deductions. Your AGI is your gross income (income before all taxes and deductions) minus deductions like student loan interest and retirement contributions.[3, 4]

If you have a 401(k) account:

That changes the calculations a bit. If you’re single and earn less than $68,000 in modified AGI, you can deduct the full amount of your traditional IRA contributions. You can take a partial deduction if you earn between $68,000 and $78,000, but after that, you can’t deduct any of your contributions.

For Roth IRAs

Roth IRA limits are a bit simpler:

If you’re single:

If you earn less than $129,000 per year, you can contribute the full limit to a Roth IRA. If you earn more than $129,000 but less than $144,000 per year, you can contribute a lesser amount. If you earn more than $144,000 per year, you cannot contribute to a Roth IRA at all.

If you’re married:

If you’re married or a qualifying widower, contribution constraints start at $204,000 per year and phase out completely at $214,000 per year. As with a traditional IRA, limits are much lower for married couples filing separately.[5]

Withdrawals

When you save money in an IRA of either kind, you shouldn’t plan on using that money until you’ve retired.

“Retirement funds should be used for retirement, allowing the long-term compounding and tax deferral to work for you,” says Steve Landersman, a certified financial planner and president of Unifi Advisors.

Since the money is supposed to be used for your golden years, if you decide to withdraw money before age 59½, you’ll be penalized.

If you withdraw money early from a traditional IRA, you’ll pay taxes on that money plus a 10% penalty.[6]

Since you contribute to a Roth IRA with after-tax funds, early distributions work a bit differently. You can withdraw the principal, or the money that you actually contributed, without penalty, at any time as long as the account has been open for five years. But if you withdraw the investment earnings on the contributions, you may owe taxes on them and/or a 10% penalty.[7]

There are exceptions to these rules, however.

“You can use limited distributions from IRA and Roth for other purposes, like education or your first-time home purchase,” Landersman says. “These exceptions avoid the early withdrawal penalty but not any taxes that are due.”

The exceptions include[6]:

  • Total and permanent disability

  • Qualified higher-education expenses

  • Home purchase for first-time homebuyers

  • Certain medical expenses

  • Distributions to military reservists called to active duty

  • Death

Landersman adds, though, that he almost never recommends withdrawing money early.

If you have to tap your retirement accounts to buy a home, you might not have the cash reserves necessary to afford any financial difficulties you might face down the road.

“Save for the down payment, use a 529 for education and keep the retirement money for later,” he says. “You’re going to need that money if you ever want to retire.”

You must start taking money out of your IRA the year you turn 72. These mandatory withdrawals are known as RMDs or required minimum distributions, and the amount you must take out will depend on your account balance and life expectancy at the time.[8]

There are no RMDs for Roth IRAs.

Which type of IRA should you choose?

You may be wondering which kind of IRA is the best choice for you.

“The decision to use a traditional IRA or Roth IRA depends on two main factors, your income and if you have a retirement plan with your employer,” Landersman says. “My general advice to clients is to maximize your pre-tax contributions in your work retirement plan and open your own Roth account.”

He adds that if you’re in the 12% tax bracket right now but will likely move into a higher bracket over time, it may make sense to only contribute to a Roth account right now.

It can be a smart move to have retirement accounts with different tax treatments in your portfolio because it gives you flexibility to make your withdrawals strategically once you’ve retired. For instance, if you sell a second home in retirement, your income will be higher that year, and you’ll be in a higher tax bracket. So that would be a good time to make your withdrawals from your Roth accounts, since those withdrawals will be tax-free.

If your employer doesn’t have a retirement plan, you can split your contributions between a Roth IRA and a traditional IRA. Just know that the $6,000 limit applies to the total amount of your contributions.

Article Sources
  1. “Retirement Topics: IRA Contribution Limits,” IRS, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
  2. “IRA Deduction Limits,” IRS, https://www.irs.gov/retirement-plans/ira-deduction-limits.
  3. “What Is Modified Adjusted Gross Income?” H&R Block, https://www.hrblock.com/tax-center/income/other-income/modified-adjusted-gross-income.
  4. “Definition of Adjusted Gross Income,” IRS, https://www.irs.gov/e-file-providers/definition-of-adjusted-gross-income.
  5. “Amount of Roth IRA Contributions That You Can Make in 2022,” IRS, https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022.
  6. “What If I Withdraw Money From My IRA?” IRS, https://www.irs.gov/newsroom/what-if-i-withdraw-money-from-my-ira.
  7. “Traditional & Roth IRAs: Withdrawal Rules and Early Withdrawal Penalties,” H&R Block, https://www.hrblock.com/tax-center/irs/tax-responsibilities/early-withdrawal-penalties.
  8. “IRA FAQs - Distributions (Withdrawals),” IRS,​ https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-distributions-withdrawals.

About the Authors

Jacqui Kenyon

Jacqui Kenyon

Jacqui Kenyon is a writer and editor, ghostwriter, editorial consultant and media coach based in Brooklyn, NY. Her work has appeared in Business Insider, Forbes, The Daily Beast, Rate.com, Fabric, and more.

Full bio
Elaine King

Elaine King CFP®

Elaine has served as the Family’s Financial Planner for over 1,200 families and 100 multigenerational family enterprises crafting actionable family financial plans.

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