What Is an IRA? Definition, 5 Types - NerdWallet (2024)

An IRA is a tax-advantaged account that helps you invest for retirement. Money can grow tax-free or tax-deferred, depending on the type of IRA.

Anyone earning an income is eligible to open a traditional IRAOther types of IRAs, such as Roths, have income limits, which means high earners may not be able to contribute.

An IRA can be opened through a bank, broker or robo-advisor.

IRAs work by taking the money you put in and investing it in stocks, bonds, exchange-traded funds or other assets.

How your account balance grows over time depends on how much you contribute to the IRA and how you invest. (See how to invest your IRA for simple investment strategies.) There are several types of IRAs, including the traditional IRA and Roth IRA for individuals, and SEP IRA and SIMPLE IRA for business owners and self-employed individuals.

While you can have more than one type of IRA, the accounts have a single annual contribution limit. And because IRAs are intended to be used for retirement, there are also withdrawal rules: You may face a 10% penalty and a tax bill if you withdraw money from a traditional IRA before age 59½, unless you qualify for an exception.

A big benefit of an IRA is that the money you invest grows either tax-free or tax-deferred.

But the tax advantages are not the only perk.

“The main benefit of an IRA is your ability to have more investment options and choices,” says certified financial planner Matt Aaron, founder of Washington, D.C.-based Lux Wealth Planning, an affiliate of Northwestern Mutual.

An employer-sponsored 401(k) may have limited investments or may not let you choose your own. And a 401(k) or pension alone may not provide enough money for you in retirement. Contributing to an IRA can offer you more access to investment options, increased retirement income and, yes, tax savings.

One downside of IRAs is that annual contributions are limited. You can contribute $23,000 to a 401(k) in 2024 and take advantage of an employer match if it’s offered. IRA contribution limits, on the other hand, are much lower.

In 2024, the maximum you can contribute among all your IRAs is $7,000 ($8,000 for those 50 or older). While you can have more than one IRA and contribute to all of them in a single year, the contribution limit is a combined limit.

Here are five popular types of IRAs and an overview of each:

1. Traditional IRA

Contributions to traditional IRAs are often tax-deductible. For example, contributing $3,000 to a traditional IRA could reduce the amount of your taxable income by $3,000. However, withdrawals from traditional IRAs in retirement are taxable as ordinary income.

Generally, you can take penalty-free distributions from a traditional IRA starting at age 59½. If you take money out before then, you may have to pay a 10% penalty (there are some exceptions). You must start taking required minimum distributions when you reach a certain age, depending on the year you were born.

If you're married and you or your spouse has a retirement plan at work, the amount of your traditional IRA contribution that you can deduct is reduced and eventually eliminated once you hit a certain income. You can still make contributions, but they won’t be tax-deductible. If you and your spouse don't have retirement plans at work, then you can deduct your IRA contribution no matter how much your income is.

2. Roth IRA

Contributions to Roth IRAs aren't tax-deductible, but regular contributions (excluding Roth conversions) can be withdrawn penalty- and tax-free at any time. Additionally, there are no taxes on investment gains when taken out during retirement. It's an attractive option for investors who have a long time before they retire, says Aaron.

“The question is, do you want to pay your taxes now or later? For me, I’d rather pay taxes now,” says Aaron.

Roth IRAs can help you combat inflation, Aaron says, because money loses value over time. He says he thinks of a Roth IRA as paying taxes on the seed vs. paying taxes on the harvest.

"I don't have the magic ball and I can never say I know what’s going to happen in the future, but if taxes go up, and you’re taking that money out in the future, you get to potentially minimize the taxes you pay.”

There are income limits for Roth IRAs, so the amount you can contribute decreases and is eventually eliminated at certain incomes. If you earn too much to contribute to a Roth IRA, you can try the backdoor Roth method instead.

3. SEP IRA

Generally, SEP IRAs are for self-employed people or small business owners with few or no employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement when distributions are taxed as income.

In 2023, contributions were limited to 25% of compensation or $66,000, whichever is less. If you applied for a tax extension by the April tax deadline, you can still contribute to your SEP IRA until Oct. 15, 2024.

In 2024, contributions are limited to 25% of compensation or $69,000. There's no catch-up contribution at age 50 or older. SEP IRAs require proportional contributions for each eligible employee if business owners contribute for themselves.

4. SIMPLE IRA

SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) are for small businesses with fewer than 100 employees. Similar to traditional IRAs, the contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.

Employee contribution limits for a SIMPLE IRA in 2023 were $15,500 per year for those under age 50. People 50 and older could make an additional $3,500 catch-up contribution for 2023. For 2024, the contribution limit rises to $16,000. The catch-up contribution remains unchanged at $3,500. Employer contributions are mandatory and can be made up until the tax filing deadline (including the extension deadline).

5. Rollover IRA

A rollover IRA isn’t exactly a type of IRA account, but a process in which you can transfer eligible assets from an employer-sponsored plan, such as a 401(k), into an IRA. People tend to do this when they're switching jobs so they can house all of their money in one place.

Two popular ways to open an IRA are through brokers and robo-advisors. If you want to choose investments for yourself, an online broker can be a good way to go. If you want help managing your retirement account, consider a robo-advisor — a service that selects low-cost and risk-appropriate investments for you.