What Is An IRA? Types And How They Work

An IRA is an account that you can use to save and invest for retirement — and it comes with valuable tax benefits. 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 one-third of private industry workers in the U.S. who don’t have access to a workplace retirement account, such as a 401(k). Too often, that lack of a 401(k) means people don’t save for retirement.

But an IRA can be a smart saving tool even for workers who do have access to a workplace 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 more money for retirement.

How does an IRA work?

Saving for retirement in an IRA versus a regular taxable brokerage account is like 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 your account.

If you don’t feel 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 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 critical to tomorrow’s earnings. Some studies have shown that asset allocation determines as much as 90% 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 stocks to bonds — without incurring capital gains taxes.

But, while you can move the money around freely within the IRA, usually you can’t withdraw it early without paying a price. An IRA is designed for retirement, which means that withdrawals from a traditional IRA before you’re 59 ½ will incur both income taxes and a hefty penalty of 10% — unless you’re using the money for a special exception, 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 difference between each is whether you pay taxes before contributing or after withdrawing funds, and when you’re required to withdraw funds.

Traditional IRA

When you withdraw funds from a traditional IRA in retirement, you’ll pay taxes on the full amount you are withdrawing. Once you turn 73, you’re required to make withdrawals or face a hefty penalty.

Anyone with earned income can contribute to an IRA. Plus, you may be eligible to claim a tax deduction in the year you make the contribution.

The only limitation on deducting your traditional IRA contribution comes into play if you, or your spouse, has a retirement account at work. That is, if you, or your spouse, has a retirement account at work and your income exceeds the following limits, the value of your deduction starts to phase out and, at higher incomes, disappears entirely (you can still contribute to an IRA; it’s simply nondeductible).

If you have a retirement account at work, then the value of your IRA deduction starts to phase out if your modified adjusted gross income (MAGI) is:

• Married filing jointly:
  • $126,000 or more in 2025
  • $129,000 or more in 2026
• Single or head of household:
  • $79,000 or more in 2025
  • $81,000 or more in 2026
• Married filing separately:
  • Less than $10,000 (not adjusted for inflation)

If your spouse has a retirement account at work, then your ability to deduct your contribution to a traditional IRA starts to phase out if your modified adjusted gross income is:

• Married filing jointly:
  • $236,000 or more in 2025
  • $242,000 or more in 2026
• Married filing separately:
  • Less than $10,000 (not adjusted for inflation)

Roth IRA

A Roth IRA doesn’t offer the instant gratification of an immediate tax break. Instead, you’ll pay your usual income taxes on the money you contribute to a Roth IRA, but you’ll owe zero taxes when you withdraw the proceeds in retirement. (There’s no requirement to make withdrawals from a Roth IRA.)

The Roth IRA contribution limit is the same as for traditional IRAs: $7,500 in 2026 ($8,600 if you’re 50 or older), up from $7,000 in 2025 ($8,000 if you’re 50 or older). You can contribute to a Roth IRA and a traditional IRA in the same year, but your combined contributions can’t exceed the annual limit.

As a rule of thumb, many financial advisors say a traditional IRA is better than a Roth IRA if you’re in a higher tax bracket now than you will be later. 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’re no longer working (and thus paying taxes later, as you do with a traditional IRA, is better).

Still, it’s very difficult to predict your tax bracket 30 years from now. Instead, look at the choice of a Roth from the perspective of diversifying your tax exposure. 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 available to self-employed people and business owners. It offers the tax advantages of an IRA, and the employer can contribute the lesser of 25% of income or $72,000 in 2026 (up from $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 self-employed people or business owners. Employees can defer their salary to their account, and employers must contribute to the account. The contribution limit for employees is $17,000 in 2026, up from $16,500 in 2025. However, employees of a company with fewer than 25 employees enjoy a contribution limit that is 10% 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 $4,000 in 2026, up from $3,500 in 2025. However, employees may face different catch-up contribution limits under some conditions. For example, savers aged 60, 61, 62 or 63 have a $5,250 catch-up contribution limit in 2026, which is unchanged from 2025.

How to open an IRA

To open an IRA, you or your spouse must 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 companies 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. 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.

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, and Roth IRAs let you withdraw your investment earnings tax-free.
• Flexibility: When you invest through a 401(k), you’re limited to the investments the plan offers. But with IRAs, your investment choices are limited only by what the broker offers. The best brokerage firms offer access to a broad range of stocks, bonds and funds. 
• 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.
• Early withdrawal penalties: With most IRAs, you’ll 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 401(k)s and IRAs offer key advantages for those looking to save for retirement. But a 401(k) is better than an IRA for several reasons:

• Company match. A 401(k) may come with a company matching contribution, meaning that you’ll receive free money from your employer if you save in your account. Typically, you’ll receive 50% to 100% of your contribution, up to 3% to 5% 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.
• Higher contribution limits. A 401(k) allows workers to save up to $24,500 in 2026 ($23,500 in 2025) compared to just $7,500 in an IRA ($7,000 in 2025).
• Higher catch-up contributions. For those 50 and older, 401(k)s let you contribute an additional $8,000 in 2026 ($7,500 in 2025). For people aged 60, 61, 62 or 63, the 401(k) catch-up limit is $11,250 in 2026 (the same as 2025). The IRA has a more modest $1,100 catch-up limit ($1,000 in 2025).

IRA FAQs

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

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  There’s no minimum amount needed to open an IRA. Brokerages may set their own minimum requirements, but often you can begin with as little as $1.

• How does an IRA make money?
  

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

• What is the average return on an IRA?
  

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  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% over time.

Bottom line

IRAs can be a good way to save for your future, whether or not you’re also contributing to an employer retirement plan like a 401(k). 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.