Individual Retirement Arrangement (IRA)

An individual retirement arrangement is a retirement savings vehicle that an individual opens and controls directly, rather than through an employer. Internal Revenue Code Section 408 creates two forms of it: an individual retirement account under Section 408(a), which is a trust or custodial account held at a bank, brokerage, or mutual fund company, and an individual retirement annuity under Section 408(b), which is an annuity or endowment contract issued by an insurance company. The IRS calls the category as a whole an "arrangement" precisely because the acronym has to cover both. In practice the overwhelming majority of IRAs are accounts, not annuities, which is why "individual retirement account" became the common expansion — but it names one branch of the category rather than the category itself.

Three rules apply to every IRA, whichever variant you hold. The first is earned income: you need wages, salary, tips, or self-employment income to contribute at all, and you can never put in more than you earned that year. Investment income, Social Security benefits, and pension payments don't count — which is why a retiree with a large portfolio and no job generally can't fund an IRA, while a teenager with a summer job can. The one workaround is a spousal IRA, where a working spouse funds an account for a non-earning one on the strength of the household's income.

The second is that the annual contribution figure is a combined cap across every traditional and Roth IRA a person owns, not a per-account allowance. Opening a second IRA does not buy a second limit; putting $5,000 into a Roth leaves only the remainder of that year's cap available in a traditional IRA. SEP and SIMPLE IRAs are the exception — funded by an employer or by a self-employed person, they run on their own, much larger limits and don't share this one.

The third is that you choose the custodian, and an IRA is a tax wrapper rather than an investment in itself, so what goes inside is largely up to you. At a bank, brokerage, or mutual fund company — the Section 408(a) account form — that usually means cash, CDs, individual stocks and bonds, mutual funds, and ETFs, a far wider range than the fixed menu of a typical workplace plan. A short list of holdings is barred by statute: life insurance and most collectibles, including art, antiques, gems, and most coins, though the law carves out certain gold, silver, and platinum coins and bullion that meet fineness standards. The Section 408(b) annuity form gets the identical tax treatment but comes from an insurance company, and its cost structure is not identical — annuity contracts can carry insurance charges and surrender periods a plain brokerage account doesn't. Custodians are not interchangeable on cost, and while you can move an IRA later, it's worth choosing deliberately up front.

The variants themselves are easiest to hold in your head as answers to three different questions. When do you pay the tax? A traditional IRA may give a deduction now and taxes every withdrawal later; a Roth IRA takes the tax now and pays qualified withdrawals out tax-free with no lifetime required minimum distributions. Each has its own income test — the traditional IRA's deduction phases out when a workplace plan is in the picture, and direct Roth contributions phase out by income outright — and those thresholds belong on the two pages themselves. Who funds it? SEP IRAs and SIMPLE IRAs are employer-side vehicles used heavily by the self-employed and small businesses. How did the money get there? A spousal IRA is funded by a working spouse for a non-earning one, a rollover IRA receives money leaving a workplace plan, and an inherited IRA holds what passes to a beneficiary under a distinct and considerably stricter set of distribution deadlines.

One rule spans the whole category at the other end: the money is meant to stay put until age 59½, and earlier withdrawals generally face a 10% early withdrawal penalty on top of any tax due. The exceptions are narrower than most people assume, and a few of them are specific to IRAs rather than workplace plans — a first home purchase up to a lifetime cap and qualified higher-education expenses are IRA exceptions that a 401(k) does not offer.

A hypothetical example of the shared rules in action: Priya, 42, earns $68,000 and has no workplace retirement plan. In March she opens a Roth IRA at a brokerage — an individual retirement account in the Section 408(a) sense — and contributes $3,000, which she invests in a low-cost index fund. In December she decides she'd rather have the rest of the year's saving be deductible, so she opens a traditional IRA at the same custodian. Her room there is not a fresh full limit: it's whatever remains of the single annual cap after the $3,000 she already put into the Roth. Two accounts, one allowance.

Her son Theo, 17, earned $2,400 mowing lawns over the summer. He can open an IRA of his own, but his contribution is capped at $2,400 — the year's limit is far higher, and irrelevant to him, because you can't contribute more than you earned. Priya's mother, retired and living on Social Security and portfolio income, has the cash to contribute and no earned income, so she can't fund one at all.

Had Priya bought an individual retirement annuity from an insurance company instead — the Section 408(b) form — the tax treatment of every dollar would be identical. What would differ is the contract wrapped around it: the insurance charges, the surrender schedule, and the narrower set of investment choices inside.

Pros

• Available to anyone with earned income, regardless of whether an employer offers a retirement plan.
• Full control over the custodian and investment lineup, with typically far more choice than a workplace plan's fixed menu.
• The traditional/Roth choice lets savers manage when tax is paid on the money — now or later.
• Roth IRAs offer tax-free growth and no lifetime required withdrawals.

Cons

• The contribution limit is much lower than a 401(k)'s, so an IRA alone rarely funds a full retirement.
• Traditional IRA deductibility phases out at moderate incomes for those covered by a workplace plan; Roth eligibility phases out entirely at higher incomes.
• Early withdrawals before 59½ are generally taxed and penalized, with only limited exceptions.
• Unlike many 401(k)s, IRAs carry no employer match — there's no free money attached.
• The annuity form of an IRA can carry insurance charges and surrender periods that a plain brokerage account doesn't, so the two forms are not interchangeable on cost.