Understanding Individual Retirement Arrangements (IRA)

Planning for retirement is a life-long concern. Because of the power of Compound Interest, saving just $60 per month after you turn 18 can grow to be worth more than $1,000,000 by the time you retire¹ – even though you would have only actually saved $36,000 in cash.

Everybody wins when you build effective retirement savings – which is why there are tax breaks that heavily encourage everyone to make regular retirement savings (making it even cheaper to earn that million-dollar retirement account). The most common program is called Individual Retirement Arrangements, or IRA accounts.

What is an IRA?

An Individual Retirement Arrangement, or IRA, is a special type of investment account that gives tax advantages for regular savings. IRA accounts are different from regular brokerage accounts because contributions you make to an IRA may get deducted from your taxable income – you get a tax break as a reward for saving for retirement.

The IRA Tax Break

What this means is that contributions you make to an IRA account might with effectively “Free Money” – because it reduces your taxable income, you save on your tax bill every time you contribute. The tax break gets cut off for high earners (as the government assumes they can save enough without help).

Tax Break Example

For a single earner, the cut-off point is earning $97,100², after that your tax break gets reduced. But this is what the “Free Money” would look like with different amounts of contributions and income levels:

Higher earners get more “Bonus Cash” because their tax rate is higher.

Contribution Limits

The example above caps out at $7,000 per year – this is because as of 2026, this is the limit on how much you can contribute to any IRA account and get any kind of tax break (you can still put in more money – but you still pay full taxes on that income).

The income threshold and contribution limits increase depending on your type of household – the example above is a single person without any dependents. If you are single but have dependents (children, or taking care of a disabled relative), this goes up. If you are married and filing your taxes together, it is doubled.

401(k) and Other Retirement Plans

If you have other retirement savings, namely a 401(k) plan, you cannot get tax benefits from both – contributing to the 401(k) means you will not get any tax benefits for contributing to the IRA too. The flip side is that a 401(k) plan is typically locked to a single employer – if you switch jobs, your 401(k) either cannot get any additional contributions, or you need to convert it into an IRA.

Withdrawing From an IRA

You can withdraw from your IRA account once you are 59.5 years old, with some limited exceptions. This is in-line with IRA accounts being designed as a “retirement savings” account. Once you reach that age, you can begin to withdraw money from your IRA – but any withdraws are counted as “income” for tax purposes (since you are able to deduct the contribution from your taxes when you make it, you need to pay the tax later when you withdraw it).

Withdrawing from an IRA early means you need to pay the income tax on whatever you withdraw immediately, plus very expensive penalties on growth (with some very limited exceptions).

Roth IRA

With a Traditional IRA, you deposit funds into the IRA account today, deducting that amount from your taxable income (which can get you the bonus cash). The catch is when you withdraw the funds when you retire, you will pay income tax on whatever you withdraw from your IRA account after you retire.

However, there is another type of IRA, called a Roth IRA (named after the US Senator who proposed them). With a Roth IRA, you do not get a deduction in the year you make the contribution – you pay the full income tax today (and do not get any “Bonus Cash”). The benefit of the Roth IRA is that the gains are tax-free – you owe no income tax when you withdraw the funds after retirement.

Which Is Better?

That depends on the investor, and how much that “bonus cash” helps their personal finances in the year they make them. If you think that you will pay less tax now than you would when you withdraw the money in retirement, a Roth IRA might make more sense (pay tax now, pay no tax on the growth later). But if getting an extra ~$1,000 this year (on a $7,000 contribution) makes a big difference in your annual budget, as it does for most people, a traditional IRA might be the better option.

As of 2024, there are about twice as many Traditional IRAs as Roth IRAs.

What Can I Invest With In An IRA?

IRA accounts have some limits on what you can invest, since they are designed for long-term savings and retirement planning – not speculative investing. In general, this means significantly more limits to leverage, day trading, and highly speculative investing than you might find in a regular brokerage account.

However, the “I” in IRA means “Individual”, so you generally have access to most, if not all, types of investments you might find in a regular brokerage account (but some brokerages might offer more options than others, depending on their specializations).

In the vast majority of cases, an IRA is used to invest in stocks, ETFs, mutual funds, and/or bonds.

Self-Directed IRA (SDIRA)

IRA accounts are designed for long-term savings, and while the bulk of IRA accounts are used for investing in stocks, bonds, or funds, it is also possible to use IRA savings for other types of investments. “Alternative” investment IRA accounts are called Self-Directed IRA accounts, and need to be set up with specialized financial institutions that are required to monitor how exactly the funds are used (which is called a “Custodian”).

Self-Directed IRA accounts can be used to invest in things like real estate, starting a business, gold or precious metals, or other long-term investments that do not necessarily flow through a typical brokerage. The key to a SDIRA is that while you give instructions to the Custodian, they execute the transactions on your behalf to ensure everything falls under the umbrella of “Long-Term Investment”.

Real Estate Investments

There are two scenarios where you can use IRA funds to buy property – a “one-time” withdraw for yourself, or an “investment” purchase through an SDIRA.

First-Time Home Buyer

You cannot normally withdraw any money from an IRA without stiff penalties – the major exception is for first-time home buyers. You can withdraw up to $10,000 with no penalties from an IRA account to go towards the down payment when buying your first home.

Investment Property

Many SDIRA providers specialize in real estate investments – meaning buying homes to rent or re-sell. Since this is an investment, it can use IRA funds for the investment. However, real estate purchased with an IRA generally cannot be mortgaged (so need to either be bough cash or use alternative financing options), and MUST be an investment property. That means you and your family absolutely cannot live in the property.

All expenses related to the property are paid out through the SDIRA account, and all rent or sale proceeds from the property are paid directly into the SDIRA account (you do not get any immediate expenses or profits that you can withdraw).

The Last Word

Individual Retirement Arrangements are the building blocks of saving for retirement in the United States, and understanding how they work is a fundamental part of understanding long-term personal finances. Opening, and contributing to, an IRA account as soon as you can after turning 18 is a key part of having a comfortable, well-funded retirement.

¹Assumes $60 monthly contributions, with growth compounding with a 10% annual interest rate, the approximate average annual return of the S&P 500.

²This is based on a “Modified Adjusted Gross Income” of $81,000 – coming out to $97,100 minus the 2026 standard deduction of $16,100. See our lesson on Income Taxes for more information.

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