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How IRAs Work

5 Min. Read
a couple learning how iras work

As the popularity of IRA, or individual retirement accounts, has grown, so has the complexity of how IRAs work and the available varieties.

IRAs were created in the 1970s to encourage workers to save for their own retirement. At first, only workers without employer-sponsored pension plans were eligible, but in 1981 all workers and their spouses became eligible to contribute to IRAs. Since then, the popularity of IRAs has grown, with approximately 25% of U.S. households now owning IRAs

Today, we have not only the original “traditional” IRA but also Roth IRAs and the two kinds of IRAs for businesses—SEP IRAs and SIMPLE IRAs. 

What Is an IRA? 

An IRA is a personal investment account that gives its owner tax advantages. Here’s how IRAs work.

The government offers these tax advantages to IRA owners because the government itself has an economic interest in its citizens and residents saving and investing for their own retirement. 

Not only do increased saving and investment rates result in a higher quality of life in retirement for retirees, but it also results in less strain on the nation’s social safety nets and greater investment in American businesses. 

To incentivize Americans to save for their own retirements, the U.S. Congress created the IRA, an investment account that rewards account owners with tax benefits in exchange for stashing away and investing funds that they generally can’t touch until they turn 59 ½ years old. 

Exactly what these tax benefits are—as well as other rules—depends on what kind of IRA a taxpayer has. 

What Are the Different Types of IRAs? 

There are four main IRA options available to Americans: 

  • Traditional IRA
  • Roth IRA
  • SEP IRA
  • SIMPLE IRA

Of these, traditional IRAs and Roth IRAs are available to most Americans, while SEP IRAs and SIMPLE IRAs can only be set up by business owners. 

Traditional IRAs 

Traditional IRAs allow taxpayers to deduct contributions to the IRA, and amounts invested within the IRA grow tax-deferred. While no tax is paid on earnings in the account, distributions from the account are taxed as ordinary income. 

Note that there are restrictions on who may deduct contributions to traditional IRAs. 

Any American with earned income who is not covered by a retirement plan at work and whose spouse is not covered by a retirement plan at work may deduct their contributions to a traditional IRA. 

However, if a retirement plan at work covers a taxpayer or their spouse, they may not be able to deduct their contributions to a traditional IRA if their income is too high. 

Roth IRAs 

Roth IRAs are the reverse of traditional IRAs in terms of tax benefits. 

Traditional IRAs work by offering a tax benefit now in the form of tax-deductible contributions. Still, they do not give a tax benefit later in retirement since distributions from traditional IRAs are taxable. 

On the other hand, Roth IRAs do not provide a tax benefit now because contributions to Roth IRAs are not deductible. Still, they provide a later tax benefit since taxpayers may take distributions out of their Roth IRA tax-free after they turn 59 ½. 

Of course, because Roth IRA contributions are not deductible, they may be withdrawn at any time without tax consequence. The withdrawal of earnings before age 59 ½ will be subject to taxes and penalties unless the taxpayer qualifies for an exception. 

Roth IRAs also have limitations on who may contribute to them based on income. Taxpayers who make too much money are not allowed to contribute directly to a Roth IRA unless they want to be subjected to a severe 6% annual excise tax. 

However, taxpayers whose income is above the Roth IRA income limitations may be able to employ the backdoor Roth IRA method to get around the income limitations. 

SEP IRAs 

SEP IRAs are traditional IRAs set up as part of a simplified employee pension (SEP). 

Employers make all the contributions to the individual employees’ SEP IRAs; there are no employee contributions. These SEP IRAs have the same rules as traditional IRAs, except they are formed as part of a business’s SEP plan. 

Unincorporated self-employed individuals can set up a SEP for themselves. 

SIMPLE IRAs 

Savings incentive match plans for employees, or SIMPLE IRAs, are retirement plans for small businesses with 100 or fewer employees. 

These plans allow employers to contribute to traditional IRAs set up for their employees within the plan. Employers are generally required to match either a 2% automatic contribution or a 3% matching contribution. 

Choosing the Right IRA for You 

Non-business owners have a simple choice between setting up a traditional or a Roth IRA. 

Generally speaking, the higher your current marginal income tax rate is and the lower you anticipate your marginal income tax rate being in retirement, the more attractive the traditional IRA is. 

This is because you would likely want to accept paying tax in the future at a lower tax bracket if it means saving on taxes now at a higher tax bracket. Conversely, the lower your current marginal income tax rate is, and the higher you anticipate your marginal income tax rate being in retirement, the more attractive the Roth IRA is. 

If you’re a business owner, the decision between a SEP IRA and a SIMPLE IRA is more complicated. Keep in mind that there are no employee contributions to a SEP IRA; you, as the employer, make all contributions. 

But with the SIMPLE IRA, both the employee and the employer make contributions, with the employer matching a percentage of each employee’s contribution. 

Where to Get an IRA 

IRAs can typically be set up at most major banks and brokerage firms, including online discount brokers. 

Understanding how IRAs work is an important first step in deciding if this is right for you as you map out the retirement you deserve.