What Is an IRA? Pros and Cons

The IRA (individual retirement account) is the classic car of retirement savings accounts. It was created by the government to give individuals a tax-advantaged retirement savings option not tied to a person’s employer. If you don’t have access to a workplace retirement plan like a 401(k), or you want to put aside additional money for the future, an IRA is your in.

Since 1974, when the IRA was introduced, other models have been added to the lineup to suit all types of savers. For example, SEP IRAs are designed for small-business owners and sole proprietors. The spousal IRA is for nonworking spouses (or ones that earn a low income). But the most newsworthy entrant to the IRA canon came in the 1990s with the debut of the Roth IRA, which provided a different type of tax break than the classic (aka traditional) IRA.

Thus concludes our IRA history lesson. Now, let’s get into the details of how these retirement accounts work.

How IRAs work

The key thing that differentiates IRAs from other types of retirement savings accounts is revealed in that first letter — “I” for “individual.” Unlike a retirement plan you access through your employer, IRAs provide individuals a lot of autonomy on how to save for the future:

You choose which financial institution to use. Opening an IRA is similar to opening a bank account. Only instead of your regular bank, in most cases you set up an account with a brokerage company. Because the field of companies vying for your IRA business is extremely competitive, it’s easy to find providers with $0 account minimums, no maintenance fees, and plenty of customer support. (We ran more than a dozen of the top online brokers through the paces to find the best IRA accounts on our sister site, StockBrokers.com.)

You decide how much money you want to contribute. There is no minimum amount you need to open an IRA (though you, or your spouse, must have earned income). But the IRS does have limits on how much it allows individuals to save each year. FYI: It can’t be more than you earn during the year. Here are the contribution ceilings for four popular IRA types:

Source: IRS.gov traditional IRA, Roth IRA 2023 and 2024, spousal IRA, SEP IRA rules

If you’re reading this in 2024, you may wonder why we included 2023 contribution limits in this table. That’s because Uncle Sam gives you until the tax filing due date (April 15, 2024) for you to contribute to an IRA for the previous year. Just make sure if you’re opening or contributing to an IRA for the previous year to indicate that it’s a 2023 contribution.

Uncle Sam gives you until the tax filing due date (April 15, 2024) for you to contribute to an IRA for the previous year.

You choose how to invest the money in the account. You fund an IRA with cash, and then you put that money to work. While some banks offer IRAs, the benefit of opening an IRA at a brokerage is that you have access to investments designed to help your money grow until you need it in retirement. Within an IRA you can pick from any of the assets your broker offers — mutual funds, individual stocks, bonds, exchange-traded funds (ETFs), and more. Unlike employer-sponsored retirement plans (401(k)s, 403(b)s and the like), you’re not limited to a pre-set menu of investment options.

You choose when you want your tax break. IRAs offer retirement savers two tax breaks.

Tax break No. 1: Everyone who invests in an IRA pays no taxes on investment growth while the money marinates in the account. That’s right: An IRA is a totally legal tax dodge. At least for a while.

Tax break No. 2: For this one, you have a choice: Take the break right now, when you fund your IRA, or save it until later when you start making withdrawals. This decision comes down to choosing either the Roth or the traditional version of an IRA.

• If you want to minimize your tax bill today, opt for a traditional IRA: With a traditional IRA, your contributions are made with pre-tax dollars. That means that the amount you put in the account is subtracted (aka deducted) from your taxable income for the year. (For example, a $5,000 contribution may lower your taxable income by $5,000.) The result: You owe the IRS less when you file your tax return for the year. Taxes eventually come back into play when you start withdrawing money from the account in retirement, at which point distributions (the fancy name for withdrawals) will be taxed as income.
• If you want tax-free withdrawals in retirement, choose a Roth IRA: With a Roth IRA, you forgo the upfront tax break you get on traditional IRA contributions. You use post-tax dollars to fund the account (that is, any money you contribute will still be counted in your taxable income for the year, just as if you hadn’t contributed it). However, withdrawals in retirement are completely tax-free because you already paid income taxes on the money before you put it in savings.

Fascinating, right? We think so, which is why we’ve devoted an entire article to explain the differences between Roth vs. Traditional IRAs.

» Price tag: See our quick and easy explainer on how much it costs to open an IRA.

Types of IRAs

In addition to Roth and traditional IRAs, there are a few other types worth knowing about. Here’s a handy comparison table to illustrate the basics of six popular types of IRAs:

Source: IRS.gov

IRS rules you should know

As pointed out earlier, anyone with earned income is allowed to contribute to an IRA. And now, the caveats: Not everyone can take full advantage of the tax benefits of traditional IRAs, and Roth IRAs prohibit high-income people from contributing.

We’ll assume you’re wondering how IRA rules affect you, personally. To answer that question, we must turn to the IRS. We apologize in advance for the nerdy details we’re about to share, but remind you: We don’t write the rules, we just report on them.

Traditional IRA deductibility rules

With a traditional IRA, if you (or your spouse, if you’re married) have a retirement plan at work, then your ability to claim a tax deduction may be limited or completely erased. If neither you (nor your better half) has a retirement plan at work, you can take the full deduction. But if one of you is covered by a workplace plan, the amount of your deduction starts to ratchet down based on your income level.

The following tables (thanks, IRS!) shows at what point deductibility of your traditional IRA contributions start to phase out depending on your tax filing status, modified adjusted gross income (AGI), and availability of a workplace retirement plan, such as a 401(k), 403(b) or 457 plan:

2023/2024 traditional IRA deduction limits if you ARE covered by a workplace retirement plan

Source: IRS.gov IRA deduction rules if you are covered by a retirement plan at work (2023 and 2024)

2023/2024 traditional IRA deduction limits if you are NOT COVERED by a workplace retirement plan

Source: IRS.gov IRA deduction rules if you (or a spouse) is not covered by a workplace retirement plan (2023 and 2024)

Roth IRA contribution rules

With a Roth IRA the amount you’re allowed to contribute starts to phase out when your earnings hit a certain level. Once again, hat tip to the IRS for providing the details:

2023/2024 Roth IRA contribution limits based on income

Source: IRS.gov Roth contribution limits for 2023 and 2024

The pros and cons of IRAs

There’s a lot to like about IRAs — everything from tax breaks to control over your retirement savings. But there are also drawbacks, mainly limits on how much the IRS allows you to contribute and the rules around making withdrawals. We’ll start by gushing about all the things that make IRAs a great tool for saving for retirement and then get into some of the potential downsides:

IRA pros

• Tax-free investment growth: All IRAs provide shelter from taxation while the money is in the account. In other words, while your money is making money for you, the IRS leaves you alone. You pay no taxes on investment growth; not a penny on capital gains or dividends. This leaves every dollar in your IRA to fuel the compounding machine — where all the money you make on your investments is added to your initial savings, with your investment returns then applying to the entire pile of cash in your account.
• An upfront tax deduction on contributions or tax-free withdrawals in retirement: Depending on the IRA type (traditional or Roth), you may qualify for a tax break when investing in an IRA — a lower tax bill come filing time. As noted above, with a traditional IRA your contributions may be deductible, thus lowering your taxable income for the year. (We say “may be deductible” because if you’re covered by a retirement plan at work, your income determines how much you can deduct.) Roth contributions are not deductible. But withdrawals from the account in retirement are completely tax-free! (Can we get a high five or a “woohoo” for that?)
• Early access to your money if you really need it: This is a Roth IRA-only perk. With a Roth IRA you’re allowed to withdraw your contributions at any time and for any reason. You won’t pay taxes or an early withdrawal penalty, either. The tax- and fee-free courtesy extends only to your contributions. Earnings, except in certain circumstances, are subject to the 10% early withdrawal penalty and may be taxed as income. (See Roth IRA vs. Traditional IRA for more.) Again, this is a Roth-only benefit. In almost all circumstances, early withdrawals (before age 59½) from a traditional IRA are subject to taxes and penalties.
• Access to lots of investment options: The ability to invest in an array of assets is a key feature of IRAs. All of the major companies that offer IRAs — Fidelity, Vanguard, Charles Schwab, E*TRADE, etc. — offer mutual funds, stocks, bonds and more. These assets historically outpace inflation … by a lot. That’s why IRAs at an investment broker are a better tool for saving for retirement than a regular bank account, or even a bank IRA, where cash and cash equivalents (like money market accounts) are your only investment options.

IRA cons

• Contribution limits: The IRS caps the amount individuals are allowed to contribute each year to tax-favored retirement accounts. On its own, the IRA’s $7,000 (or $8,000 if you’re age 50 or older) limit may seem reasonable. But it doesn’t compare to the $23,000 (or $30,500 for the 50-plus set) individuals can save in an employer-sponsored retirement plan like a 401(k). These contribution limits inherently reduce the size of any tax benefits and potential investment growth you can get if you’re only using an IRA to invest for retirement. (See more in our comparison of IRAs vs. 401(k)s.)
• Potential eligibility issues: Not everyone is able to take full advantage of the tax benefits IRAs offer. With a traditional IRA, if you (or your spouse, if married) have no retirement plan at work, you can take the full deduction. But if one of you is covered by a workplace plan, the amount of your deduction starts to ratchet down based on your income. With a Roth IRA, the amount you’re eligible to contribute starts to phase out when your income hits a certain level. See the tables above for the cold hard numbers.
• Required minimum withdrawals (RMDs): Whether you need to tap the money or not, the IRS requires you to start withdrawing money from a traditional IRA (not a Roth) starting at age 72. If you fail to take RMDs, you’ll pay a pretty stiff penalty: a 50% tax on the amount you were supposed to withdraw on top of whatever income taxes you owe.
• Potential penalties on early withdrawals: IRAs are designed for long-term savings, as the “R” (for “retirement”) in the acronym implies. The rules stipulate that you aren’t supposed to withdraw money from the account before the year you turn age 59½. Breaking the protected tax shield earlier subjects you to a 10% early withdrawal penalty on the amount you take out, on top of whatever income taxes you may owe. There are circumstances where the 10% penalty is waived on early withdrawals (e.g., medical hardships, qualified higher education expenses, first-time home purchase).

One of the great things about IRAs is that they allow you to take control of your retirement savings. And perhaps the the biggest decision is which type of IRA to use — a Roth IRA, traditional IRA, or both at the same time. Conveniently enough, we dive into Roth IRA vs. Traditional IRA later in this retirement account series.

References

IRS.gov Traditional IRAs, IRS.gov Roth IRAs, Exceptions to Tax on Early Distributions, IRS.gov Contribution Limits for 2024, IRS.gov Roth Contribution Limits for 2023, IRS.gov IRA Deduction Rules for Work Retirement Plans 2023, IRS.gov IRA Deduction Rules if Not Covered by Workplace Retirement Plan 2023