What is an IRA and How Do You Open One?

If your employer does not offer a 401(k), or if you have already contributed enough to get your full employer match and want to invest even more, an IRA is your next best step.

Opening an IRA is as easy as opening a standard bank account, but it offers massive tax benefits that standard savings accounts do not. Here is everything you need to know to get started.

The Two Main Types: Traditional vs. Roth

When you go to open your account, you will be asked to choose between a Traditional IRA and a Roth IRA. The only major difference between them is when you pay taxes to the IRS.

1. Traditional IRA (Pay Taxes Later)

With a Traditional IRA, the money you contribute is "tax-deductible" today. This means if you put $5,000 into a Traditional IRA this year, you get to deduct that $5,000 from your taxable income when you file your tax return, lowering your immediate tax bill. However, when you retire and take the money out, you will have to pay standard income taxes on every dollar you withdraw.

2. Roth IRA (Pay Taxes Now, Never Again)

With a Roth IRA, you contribute "after-tax" money. You do not get a tax break today. However, the money grows completely tax-free forever. When you retire and withdraw the money, you owe zero taxes to the government.

The Contribution Limits

Because IRAs offer such incredible tax loopholes, the US government strictly limits how much money you can put into them each year.

The IRS adjusts this limit periodically based on inflation. For most adults under age 50, the limit is generally around $7,000 per year (as of recent tax years). If you are 50 or older, the IRS allows you to make "catch-up contributions," letting you put in an extra $1,000 per year.

Note: You must have "earned income" (money from a job or business) to contribute. You cannot contribute more than you earned that year.

How to Open an IRA in 3 Steps

1. 1

   Pick a Brokerage

   You do not open an IRA at a normal bank like Chase or Wells Fargo. You open it at an investment brokerage. The industry standard favorites for low fees and ease of use are Fidelity, Vanguard, and Charles Schwab.

2. 2

   Transfer Funds

   Once your account is open, link your checking account and transfer money into the IRA. You can set up an automatic monthly transfer (e.g., $500/month) so you don't even have to think about it.

3. 3

   Invest the Money (Crucial Step)

   When the money hits your IRA, it sits in a cash "settlement fund" doing absolutely nothing. You must actively buy investments. For beginners, buying a broad index fund (like the S&P 500) or a Target Date Retirement Fund is the easiest way to ensure your money actually grows.

Frequently Asked Questions

Q: Can I have both a 401(k) and an IRA? A: Absolutely! In fact, personal finance experts highly recommend having both. A common strategy is to contribute exactly enough to your 401(k) to get the employer match, then max out a Roth IRA, and then return to the 401(k) if you still have money to invest.

Q: What happens if I need the money before retirement? A: Similar to a 401(k), withdrawing investment gains from an IRA before age 59½ will trigger a 10% penalty plus taxes. However, the Roth IRA has a special exception: you can withdraw your original contributions (but not the growth) at any time, completely penalty-free.

Q: Can I lose all my money in an IRA? A: An IRA is just an empty bucket. Whether you make or lose money depends entirely on what you put inside the bucket. If you buy highly risky individual stocks, you could lose money. If you buy diversified index funds and leave them alone for 30 years, historical data shows your wealth will grow significantly.