IRA Basics: How Individual Retirement Accounts Work

An Individual Retirement Arrangement (IRA) is a personal savings plan with tax advantages for retirement, separate from any employer-sponsored plan like a 401(k). The purpose is to provide a tax-favored way to accumulate funds over your working years, supplementing other retirement income sources.

These are holding accounts for investments like stocks, bonds, and mutual funds. Depending on the account type, you can receive immediate tax breaks on contributions or secure tax-free income in retirement. This structure allows your investments to grow over time with a tax advantage.

Understanding Traditional and Roth IRAs

The two most common types of IRAs are the Traditional and Roth, which are defined by their distinct tax treatments. With a Traditional IRA, investments grow tax-deferred, so you do not pay taxes on the investment earnings each year. Depending on your income and whether you are covered by a retirement plan at work, your contributions may be tax-deductible in the year you make them.

When you withdraw funds from a Traditional IRA during retirement, the distributions are treated as ordinary income and are taxed accordingly. This includes both your deductible contributions and any earnings the account has generated. This structure can be advantageous for individuals who anticipate being in a lower tax bracket during their retirement years.

A Roth IRA operates with the opposite tax structure. Contributions to a Roth IRA are made with after-tax dollars, meaning you do not receive an upfront tax deduction. The benefit of a Roth IRA emerges during retirement, when qualified withdrawals of contributions and earnings are completely tax-free. For a withdrawal to be qualified, distributions must be taken after you reach age 59½ and have had the account open for at least five years.

Contribution Rules and Limits

The Internal Revenue Service (IRS) sets specific rules that govern how much you can contribute to an IRA each year. For 2025, the maximum amount you can contribute to all of your Traditional and Roth IRAs combined is $7,000. This limit is subject to periodic adjustments for inflation by the IRS, and your total contributions cannot exceed your taxable compensation for the year.

A “catch-up” provision allows individuals nearing retirement to boost their savings. If you are age 50 or older, you are permitted to contribute an additional $1,000 for 2025. This brings the total potential contribution for those age 50 and over to $8,000.

The deadline for making IRA contributions for a specific tax year is the same as the deadline for filing your federal income tax return, which is typically April 15th of the following year. This rule allows you to make contributions for the previous year up until the tax filing deadline, not including extensions. For instance, you can make contributions for the 2025 tax year until mid-April 2026.

Eligibility to contribute to a Roth IRA is subject to income limitations based on your Modified Adjusted Gross Income (MAGI). For 2025, a single filer’s ability to contribute begins to phase out at a MAGI of $150,000 and is eliminated at $165,000. For married couples filing jointly, the phase-out range is between $236,000 and $246,000.

While anyone with earned income can contribute to a Traditional IRA, the ability to deduct those contributions also depends on your MAGI if you or your spouse are covered by a retirement plan at work. 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 a married couple filing jointly where the contributing spouse is covered by a workplace plan, the phase-out range is $126,000 to $146,000.

Withdrawal Regulations

If you withdraw funds from an IRA before you reach age 59½, the withdrawal is considered an early distribution. In addition to any ordinary income tax due, the taxable portion is subject to a 10% additional tax penalty.

There are several exceptions to this 10% penalty, allowing you to access funds early for certain life events. These include:

• Using the funds for a first-time home purchase, with a lifetime limit of $10,000.
• Paying for qualified higher education expenses for yourself, your spouse, children, or grandchildren.
• Distributions taken due to total and permanent disability.
• Certain unreimbursed medical expenses.
• Payments made to a beneficiary after your death.

For Traditional IRAs, you are required to start taking withdrawals, known as Required Minimum Distributions (RMDs), once you reach a certain age. You must begin taking RMDs by April 1 of the year after you turn 73. The amount you must withdraw is calculated based on your account balance and your life expectancy as determined by IRS tables, and failing to take the full amount can result in a tax penalty.

A distinction of the Roth IRA is that the original owner is not required to take any RMDs during their lifetime. This allows the funds within a Roth IRA to continue growing tax-free, providing greater flexibility in managing your retirement assets.

Opening and Funding Your Account

To open an IRA, first select a financial institution to act as the custodian for your account. Your options include brokerage firms, which offer a wide range of investment choices; banks and credit unions, which may offer more conservative options like CDs; and robo-advisors, which provide automated investment management.

Once you have chosen a provider, you will need to complete an application. This requires providing personal information such as your name, address, date of birth, and Social Security number. You will also need to designate a beneficiary, and the application process is often completed online.

After your account is open, you can fund it. You can make a contribution via an electronic transfer from your bank account, by mailing a check, or by setting up recurring automatic contributions. You can also fund your IRA by moving money from an existing retirement plan, such as a 401(k) from a former employer, in a process known as a rollover. A direct rollover is often the simplest way to avoid any tax withholding complications.