What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is a tax-advantaged investing tool that individuals use to earmark funds for retirement savings. There are several types of IRAs.

  • Traditional IRAs
  • Roth IRAs
  • SEP IRAs

Key Takeaways

  • IRAs are tax-advantaged investing tools for individuals to earmark their retirement savings.
  • Depending on the individual's employment status, IRAs can be of various types and have different tax liabilities.
  • If you withdraw money from an IRA before age 59?, you are usually subject to an early-withdrawal penalty of 10%.
  • There are income limitations for contributing to Roth IRAs and deducting contributions to traditional IRAs.
  • Rules regarding maximum contributions and income limits for IRAs change each year.

Understanding Individual Retirement Accounts (IRAs)

So how does an IRA work? Investments held in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds. A self-directed IRA can be a traditional IRA or a Roth IRA. Self-directed IRAs allow investors to make all the decisions and give them access to a broader selection of investments, including real estate, private placements, and tax liens.??

Individual taxpayers can establish either traditional and Roth IRAs, while small-business owners and self-employed individuals set up SEP and SIMPLE IRAs. An IRA must be opened with an institution that has received Internal Revenue Service (IRS) approval to offer these accounts. Choices include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Most individual investors open IRAs with brokers.??

Note that you can only contribute to an IRA with earned income that meets IRA rules. Income from investments, Social Security benefits, or child support does not count as earned income.??

Because IRAs are meant for retirement savings, there is usually an early withdrawal penalty of 10% if you take money out before age 59?. Depending on what type of IRA you have, you may also need to pay income tax on your early withdrawal.??

As of 2008, per Revenue Ruling 2008-5, IRA transactions may also trigger the wash-sale rule. Should shares be sold in a non-retirement account, followed by substantially identical shares being purchased in an IRA within a 30 day period, the investor cannot claim tax losses for the sale. The investment's basis in the individual's IRA won't be increased either.??


Roth IRA Vs. Traditional IRA

Types of IRAs

Traditional IRA

In most cases, contributions to traditional IRAs are tax-deductible. If someone puts $6,000 into an IRA, that person's taxable income decreases by the amount of the contribution. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate. As of 2020, annual individual contributions to traditional IRAs cannot exceed $6,000 in most cases. If you are 50 or older, you can contribute up to $7,000 per year using catch-up contributions.??

Your income and whether you have a retirement plan at work influence which types of IRAs you can open and whether your contributions will be tax-deductible.??

For 2021, the IRS left the IRA contribution limits unchanged.?? However, they changed the income phaseout range for deducting contributions to a traditional IRA for investors with retirement plans at work. The phaseout range changed from $104,000–$124,000 to $105,000–$125,000 for married couples and from $65,000–$75,000 to $66,000–$76,000 for singles.??

Several key factors determine if you can deduct your traditional IRA contributions. Suppose that you are a single person or file as head of household and have a retirement plan, such as a 401(k) or 403(b), available at work. Then, your traditional IRA contributions are fully deductible if your modified adjusted gross income (MAGI) was $65,000 or less in 2020. The following year the amount will go up to $66,000. If you're married filing jointly, the limit is $105,000 or less in 2021. If you earn more, you begin to lose deductions. Use this chart to figure out where you fit.???

Deduction Limits If You Have a Retirement Plan at Work
Filing Status 2020 MAGI 2021 MAGI Deduction
Single or Head of Household      
  Less than $65,000 Less than $66,000 Full deduction up to your contribution level
  More than $65,000 but less than $75,000 More than $66,000 but less than $76,000 Partial deduction
  $75,000 or more $76,000 or more No deduction
Married Filing Jointly      
  Less than $104,00 Less than $105,000 Full deduction up to your contribution level
  More than $104,000 but less than $124,000 More than $105,000 but less than $125,000 Partial deduction
  $124,000 or more $125,000 or more No deduction
Married Filing Separately      
  Less than $10,000 Less than $10,000 Partial deduction
  $10,000 or more $10,000 or more No deduction

Starting at age 72, holders of traditional IRAs must begin taking required minimum distributions (RMDs), which are based on their account size and life expectancy. Failure to do so may result in a tax penalty equal to 50% of the amount of the required distribution.

In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age requirement of taking RMDs from 70? to 72. It also eliminated the age limit of when a person can contribute to an IRA, which was 70?. A person of any age with earned income can now contribute to an IRA.??

Roth IRA

Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. You contribute to a Roth IRA using after-tax dollars, but you do not face any taxes on investment gains. When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs also do not have RMDs. If you don't need the money, you don't have to take it out of your account. You can still contribute to a Roth IRA as long as you have eligible earned income, no matter how old you are.??

Roth IRA contribution limits for 2020 and 2021 are the same as for traditional IRAs.?? The maximum amount is $6,000 for investors under age 50. If you are 50 or older, the limit rises to $7,000.??

However, there is a catch. There are income limitations for contributing to a Roth IRA.?? The phase-out range for single filers is between $124,000 to $139,000 in 2020 and between $125,000 to $140,000 in 2021. For married couples filing joint taxes, the phase-out range begins at $106,000 to $196,000 in 2020 and goes up to $108,000 to $198,000 in 2021.??

Income Limitations for Contributing to a Roth IRA
Filing Status 2020 MAGI 2021 MAGI Contributions
Single or Head of Household      
  Less than $124,000 Less than $125,000 Up to the limit
  $124,000 to less than $139,000 $125,000 to less than $140,000 Reduced amount
  $139,000 or more $140,000 or more Zero
Married Filing Jointly or Qualifying Widow(er)      
  Less than $196,000 Less than $198,000 Up to the limit
  $196,000 to less than $206,000 $198,000 to less than $208,000 Reduced amount
  $206,000 or more $208,000 or more Zero
Married Filing Separately      
  Less than $10,000 Less than $10,000 Reduced amount
  $10,000 or more $10,000 or more Zero


Self-employed individuals, such as independent contractors, freelancers, and small-business owners, can set up SEP IRAs. The acronym SEP stands for "simplified employee pension." A SEP IRA adheres to the same taxation rules for withdrawals as a traditional IRA. For 2020, SEP IRA contributions are limited to 25% of compensation or $57,000, whichever is less. In 2021, it goes up to $58,000.?? ??

Business owners who set up SEP IRAs for their employees can deduct the contributions. However, company employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.??


The SIMPLE IRA is also intended for small businesses and self-employed individuals. The acronym SIMPLE stands for "savings incentive match plan for employees."?? It also follows the same taxation rules for withdrawals as a traditional IRA. Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions as well. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket.?? The SIMPLE IRA employee contribution limit in 2020 is $13,500, and the catch-up limit (for those workers age 50 and older) is $3,000. These amounts remain unchanged in 2021.??

Compare the Options

Use the chart below to get a better sense of how the different IRAs work. Note that traditional and Roth IRAs require employment income.?? However, individual taxpayers can open traditional and Roth IRA accounts on their own. SEP IRAs and SIMPLE IRAs require your employer to set up the plan.?? You cannot establish a SEP or SIMPLE IRA for yourself unless you are self-employed.??

Note: To see the full chart, use the slider at the bottom to see the column at the far right.

Comparing IRA Types

IRA Type


?Contribution Limit (2021)


Tax-Deductible Contributions?


Tax-Free Distributions?


Subject to Required Minimum Distributions Beginning at Age 72?


Who Can Establish




$6,000; $7,000 if age 50 or older


Yes, but individual deduction amounts are based on income, filing status, and retirement plan coverage through your employer






Individual taxpayers and couples*



$6,000; $7,000 if age 50 or older








Individual taxpayers and couples*, subject to MAGI limitations




The lesser of 25% of compensation or $58,000


Business deductions for employee contributions are limited to the lesser of your total contributions or 25% of employees’ compensation


Self-employed individuals must use a special formula to calculate the amount of contributions they can deduct






Small business owners and self-employed individuals




$13,500; $16,500 if age 50 or older


All contributions made to employees’ SIMPLE IRAs by the plan owner are tax deductible


Self-employed individuals can also deduct contributions made to their own SIMPLE IRA






Small business owners and self-employed individuals