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What is an IRA? Everything you need to know

A closer look at what you need to know before opening an individual retirement account.

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If you’re an employee thinking about how you can save for retirement, individual retirement accounts, better known as IRAs, are worth considering. Almost anyone with earned income can open an IRA, which makes it different from a 401(k), which you can only participate in if your employer offers one. There are several different types of IRAs, each with its own requirements and features, but all offer important tax advantages that could help you save more for your future.

The most popular kinds of IRAs are traditional IRAs and Roth IRAs. The combined maximum yearly contribution to both accounts is $6,500 for 2023—or $7,500 if you will be age 50 or older at any time during the calendar year. Here’s what you need to know to help you choose an IRA.1

What are traditional IRAs?

Traditional IRAs provide tax-deferred growth. This means your money grows tax-free until you begin taking distributions, at which point your withdrawals are taxed at your income tax rate.2 What’s more, contributions may be tax-deductible. For instance, if you make $40,000 per year and put $3,000 in a traditional IRA, you will generally receive a deduction against your $40,000 of income.

For 2023, if you are covered by a workplace retirement plan, your contributions are at least partially tax-deductible if your modified adjusted gross income is less than $83,000 if you are single or $136,000 if you are married and filing jointly. The income limits are higher if your spouse is covered by a workplace retirement plan but you are not. However, if neither you nor your spouse are covered by a workplace retirement plan, your contributions are tax-deductible no matter what your income is.

A traditional IRA can be useful for those who don’t qualify for a Roth IRA (see next section), for those who anticipate being in a lower tax bracket after retirement and for those who want to save outside their 401(k). It makes sense to invest enough in your 401(k) to get the full matching contribution from your employer, if they offer one. Beyond that, IRAs may offer more investment flexibility than many 401(k)s, though you should learn the details of your 401(k) to be sure. Anyone with earned income3 is eligible to open a traditional IRA. If you withdraw funds from your traditional IRA before age 59½, however, you generally have to pay income tax on any tax-deductible contributions and earnings, and an additional 10 percent tax on your withdrawal—though some exceptions may apply.

What are Roth IRAs?

Roth IRAs are attractive accounts for those who can afford to pay taxes now for the reward of federally tax-free income later (state taxes may apply). Since contributions to Roth IRAs aren’t tax-deductible, you pay more in income taxes up front than you would with a tax-deductible contribution to a traditional IRA. The trade-off is when you withdraw your contributions, you get to take home the full amount federal tax-free (as long as at least five years have passed since your first Roth IRA contribution and you’re older than 59½ or you meet another exception). In addition, unlike tax-deductible contributions to traditional IRAs, contributions to a Roth IRA can be withdrawn at any time, tax-free (including the 10% early withdrawal tax), although taxes (including the 10% early withdrawal tax) may apply to the portion of the withdrawal representing earnings.

One other feature that sets the Roth IRA apart from the traditional IRA: There are no required minimum distributions while the Roth IRA owner is still alive. However, to contribute for 2023, you must have earned income, and single tax filers must make less than $153,000 per year, while joint tax filers must make less than $228,000 per year. The IRS adjusts these limits annually.

You may contribute to both a traditional and a Roth IRA, though there is an annual contribution limit—for 2023, the maximum combined limit across both accounts is $6,500 (or $7,500 if you will be age 50 or older at any time during the calendar year).

What are IRAs for the self-employed?

A simplified employee pension (SEP) IRA can be a good option for those who are self-employed. SEP IRAs allow you to set aside up to 20% of your net earnings from self-employment (as determined under the SEP IRA rules),4 up to $66,000 through 2023.5

SEP IRAs work like traditional IRAs, which means you don’t pay taxes on your contributions and earnings until you withdraw them in retirement. There is no Roth option for SEP IRAs.

2023 IRA comparison
Traditional IRA Roth IRA SEP IRA
Income limits None Less than $153,000 single, Less than $228,000 married couples filing jointly None
Annual contribution limits $6,500 under 50, $7,500 if 50 and over at any time during the calendar year4 $6,500 under 50, $7,500 if 50 and over at any time during the calendar year4 20% of net earnings from self-employment (as determined under SEP IRA rules)6 up to $66,0004
Tax breaks Contributions may be tax-deductible, depending on your income and if you or your spouse are covered by a workplace retirement plan Contributions are not tax-deductible Contributions are generally tax-deductible
Taxes on withdrawals Taxed as ordinary income2 None7 Taxed as ordinary income2
Required distribution age 738 No RMDs required during the owner's life, but RMDs are required following death 738
Additional Tax Withdrawals before age 59½ are generally subject to income tax and an additional 10% tax Withdrawals of earnings before age 59½ are generally subject to income tax and an additional 10% tax Withdrawals before age 59½ are generally subject to income tax and an additional 10% tax

What are savings IRAs vs. investment IRAs?

Once you determine your account type, you may be able to choose between an investment IRA and a savings IRA. Think about your retirement goals, your financial health and your life stage to help you determine which kind of IRA would be better for you. Savings IRAs are offered by banks and feature FDIC-insured CDs and money market savings accounts. These are lower-risk accounts that offer the potential for relatively stable, modest yearly returns, often without any annual or custodial fees.

Investment IRAs are offered by investment firms and may allow you to invest in stocks, bonds, exchange-traded funds (ETFs) and mutual funds. These accounts may make sense for those who are willing to accept some risk in their retirement accounts in exchange for the potential for greater long-term growth. Investment IRAs are not FDIC-insured, are not bank guaranteed and have the potential to lose value.

No matter which kind of IRA you choose, saving or investing for retirement should be at the top of your list of financial priorities. With retirements lasting longer than they used to, the sooner you start preparing, the better off you could be.

  1. This article addresses U.S. federal tax consequences. State and local taxes may also apply. Consult your tax advisor.
  2. Withdrawals in excess of non-deductible contributions are taxed. Withdrawals before age 59-1/2 may be subject to a 10% additional tax unless an exception applies.
  3. A spouse can also contribute to a traditional IRA on behalf of a spouse who has no earned income, provided the contributing spouse has enough earned income to cover the contributions.
  4. Taxpayers typically have until their individual federal tax return filing deadline (April 18 for 2023) to make an IRA contribution for the prior tax year. If the taxpayer has filed an extension, then the taxpayer has until the extension deadline, which is usually October 15, to make a SEP IRA contribution.
  5. This article does not address SARSEPs (or salary reduction SEPs) or SIMPLE IRAs which can also be used by those who are self-employed if certain requirements are met.
  6. The maximum compensation that can be taken into account for purposes of this calculation is $330,000 in 2023.
  7. Tax-free withdrawals (i.e., qualified distributions) are generally allowed if you're 59 1/2, disabled or deceased, and five years have passed since your first contribution to any Roth IRA.
  8. Effective 1/1/2023, the required beginning date is April 1 of the year after you turn age 73. You are required to take an RMD by December 31 each year after that. If you delay your first RMD until April 1 in the year after you turn 73, you will be required to take two RMDs in that year. You may be subject to additional taxes if RMDs are missed. Please see your tax advisor regarding your specific situation.

Source: IRS, 2023

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The material provided on this website is for informational use only and is not intended for financial, tax or investment advice. Bank of America and/or its affiliates, and Khan Academy, assume no liability for any loss or damage resulting from one’s reliance on the material provided. Please also note that such material is not updated regularly and that some of the information may not therefore be current. Consult with your own financial professional and tax advisor when making decisions regarding your financial situation.

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