How Does an IRA Work? From Contributions to Withdrawals

An Individual Retirement Arrangement, known as an IRA, is a savings plan with tax advantages for long-term investment. It is not an investment itself, but a type of account that holds various investments, shielding them from annual taxation as they grow. The purpose of an IRA is to encourage personal savings for retirement by offering these tax benefits, creating a source of income to supplement other resources.

Types of Individual Retirement Accounts

The two most prevalent types of IRAs are the Traditional IRA and the Roth IRA, each offering a distinct approach to tax savings. A Traditional IRA allows individuals to make contributions that may be tax-deductible, lowering their taxable income for the year. The investments grow on a tax-deferred basis, and taxes are paid when funds are withdrawn in retirement, at which point they are treated as ordinary income.

In contrast, a Roth IRA operates on an opposite tax structure. Contributions are made with after-tax dollars, so there is no upfront tax deduction. The benefit is that both investment growth and qualified withdrawals in retirement are tax-free. This can be advantageous for individuals who anticipate being in a higher tax bracket during retirement than they are in their current working years.

The choice between a Traditional and Roth IRA depends on an individual’s current and expected future financial situation and tax bracket. While Traditional and Roth IRAs are for individual savers, other types exist for small business owners and the self-employed. A Simplified Employee Pension (SEP) IRA allows business owners to make contributions for themselves and their employees, and a Savings Incentive Match Plan for Employees (SIMPLE) IRA is another option involving both employer and employee contributions.

Funding Your IRA

To contribute to an IRA, an individual must have taxable compensation, or earned income. This includes wages, salaries, commissions, and self-employment income. Income from investments, pensions, or annuities does not qualify for making IRA contributions.

The IRS sets annual contribution limits. For both 2024 and 2025, the maximum contribution is $7,000. Individuals age 50 or older can make an additional “catch-up” contribution of $1,000, for a total of $8,000 for the year.

Eligibility to contribute to a Roth IRA is dependent on your modified adjusted gross income (MAGI). For 2025, a single filer’s ability to contribute begins to phase out with a MAGI between $150,000 and $165,000. For those who are married and filing jointly, the phase-out range is between $236,000 and $246,000. If your income exceeds the upper limit, you cannot contribute to a Roth IRA for that year.

The rules for deducting Traditional IRA contributions depend on income if you or your spouse are covered by a retirement plan at work. If neither has a workplace plan, you can deduct your full contribution. For 2025, if you are single and covered by a workplace plan, the deduction phases out with a MAGI between $79,000 and $89,000. For married couples filing jointly where the contributing spouse has a workplace plan, the phase-out range is $126,000 to $146,000. The deadline to make contributions for a tax year is the filing deadline, usually April 15 of the following year.

Investing and Growth Within an IRA

When you contribute money to an IRA, you must select specific investments to purchase. A wide array of investment options can be held within an IRA, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). These investments allow savers to build a portfolio aligned with their risk tolerance and financial goals.

The primary advantage of holding investments inside an IRA is tax-sheltered growth. In a Traditional IRA, investments grow tax-deferred. This means that as assets increase in value or generate income, no annual taxes are due, allowing the full amount to compound over many years.

For a Roth IRA, the growth is tax-free. Because contributions are made with money that has already been taxed, the investments grow without any future tax obligation on the earnings.

Withdrawing Funds from an IRA

Taking money out of an IRA is a distribution. You must be at least 59½ years old to withdraw funds from your IRA without incurring a 10% early withdrawal penalty from the IRS. This rule discourages using retirement savings for non-retirement purposes.

If you take a distribution before age 59½, the amount is subject to ordinary income tax and the 10% penalty. However, the IRS allows for several penalty exceptions, including for:

• A first-time home purchase, up to a $10,000 lifetime limit
• Qualified higher education expenses
• Certain medical expenses exceeding 7.5% of your adjusted gross income
• Expenses related to a birth or adoption, up to $5,000
• Death or total and permanent disability of the account owner

The tax treatment of the distribution depends on the IRA type. For a Traditional IRA, all pre-tax contributions and their earnings are taxed as ordinary income when withdrawn. For a Roth IRA, qualified distributions are tax-free. A Roth distribution is qualified if the account has been open for at least five years and the owner is at least 59½ years old or meets another exception, like disability.

The SECURE 2.0 Act established that individuals must begin taking Required Minimum Distributions (RMDs) from Traditional, SEP, and SIMPLE IRAs. The age to begin RMDs is 73 for those born between 1951 and 1959, and it will increase to 75 for those born in 1960 or later. Failing to take the full RMD can result in a penalty of 25% of the amount not withdrawn. Roth IRAs do not have RMDs for the original owner.

Moving IRA Funds

It is often necessary to move retirement funds between accounts. There are two methods for moving IRA funds without creating a taxable event: direct and indirect rollovers. A direct rollover, or trustee-to-trustee transfer, is where the financial institution holding your current IRA sends the money directly to the new one.

The second method is an indirect rollover, where you receive a check from your IRA. You have 60 days from the date you receive the funds to deposit them into another IRA. If you miss this 60-day deadline, the IRS will treat the amount as a taxable distribution and may apply the 10% early withdrawal penalty if you are under age 59½.

A restriction applies to indirect rollovers between IRAs. An individual is permitted to make only one such IRA-to-IRA rollover within any 12-month period. This rule applies across all of your IRAs, and violating it can lead to the second rollover being treated as a taxable distribution.

These movement rules are used when an individual leaves an employer and wants to move a 401(k) balance into an IRA or to transfer an existing IRA to a new brokerage firm. Due to the potential for error with indirect rollovers, the direct trustee-to-trustee transfer is the recommended approach to ensure a seamless and tax-free movement of retirement savings.