What is an IRA and How Does it Work?

The majority of Americans are concerned about not having enough money for retirement. According to data from the Federal Reserve, the U.S.’s central bank, more than two-thirds of U.S. non-retired adults – 69% – either do not believe their retirement savings are on track or aren’t sure. What’s more, over a quarter of them – 28% – have no retirement savings whatsoever.¹   

Now here’s the good news: If you belong to this group and want to turn your situation around – or simply want to stash more funds away for the future – an IRA offers you a way to help get your savings on track. 

What Is an IRA?

An IRA – which stands for Individual Retirement Arrangement – is an account you open at a qualified financial institution that allows you to save for retirement in a tax-advantaged way. There are two main types of IRAs, each with different advantages: 

• Traditional 
• Roth 

Advantages of Traditional IRA Accounts

Traditional IRAs allow qualified individuals to make contributions with pre-tax dollars – meaning that they may be able to deduct what they contribute from the income reported on their tax return.² Then, any earnings on these savings will grow on a tax-deferred basis until the account holder reaches a certain age and withdraws the money. This lets you generate more savings, since the money you would have otherwise paid out to taxes each year continues to earn interest and grow in your account. 

Still, many people enter a lower tax bracket once they retire and stop working. If you do, when you finally withdraw your savings from your IRA you may pay less in taxes than you would have if you paid them when you first earned the money while you were working. 

The portion of your contributions that can be deducted from your income taxes changes, however, depending on your income level and whether you or your spouse (if any) are covered by a retirement plan at work.³Here’s an example: For 2023, you can contribute up to $6,500 and deduct all of it if you are single, are covered by a retirement plan at work, and earn $73,000 or less. If you earn more than $73,000 but less than $83,000 you can deduct a portion of your contribution. If you’re single and earn more than $83,000, none of it is deductible. These thresholds change if you’re not covered by a retirement plan at work, or if you’re married.⁴

These figures are subject to change every year. For example, between tax year 2022 and 2023, the annual traditional IRA contribution limit increased from $6,000 to $6,500 for those under 50.⁵ 

Here are a few other key points to know about traditional IRAs:

• Withdrawals before the age of 59 1/2 may lead to penalties.⁶
• AAt age 72, if you turn 72 before December 31, 2022, or 73, if you turn 72 after December 31, 2022, you must start taking money out of your IRA in what’s called “required minimum distributions,” or RMDs. Otherwise, again, you may be subject to penalties.⁷ 
• You can contribute to an IRA even if your income is above the deductibility threshold – you just won’t get the tax advantage of a current deduction. On the plus side, though, you won’t pay income tax on the nondeductible portion of your IRA when you withdraw money.⁸

Another way to fund your IRA is through a “rollover.” You can contribute money to a traditional IRA that is "rolled over" from another qualified retirement plan – usually one that was sponsored by a former employer. The advantage of a rollover is that it allows you to consolidate all of your retirement savings from employer-sponsored plans, such as a 401(k) or 403(b), into a single IRA, where it is easier to manage and can continue to accumulate tax free.⁹ 

Advantages of Roth IRA Accounts

With a Roth IRA, you make contributions with after-tax dollars, but your savings grow tax-free. That means that when you withdraw your money, you get to keep it all. And unlike other types of retirement accounts, with a Roth IRA you’re not required to begin withdrawing a portion of the funds each year at age 72, meaning all of your savings can continue to accumulate tax free for as long as you like. Unlike contributions to a traditional IRA, contributions to a Roth IRA are not tax deductible and you cannot contribute in years your income is above the IRS limit.¹⁰ 

Once you open a Roth IRA, you have to wait a minimum of five years before you can withdraw the earnings on your savings tax-free.¹¹ But unlike a traditional IRA, another advantage to a Roth account is that you can withdraw your original contributions without penalty at any time.¹²