How Do IRAs Actually Work?

**Mark Riepe** (0:10)
I'm Mark Riepe. I head up the Schwab Center for Financial Research, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decision-making, and the cognitive and emotional biases that can cloud our judgment.
The topic this week was motivated by the fact that 2026 is the 45th anniversary of the Economic Recovery Tax Act of 1981 That piece of legislation dramatically expanded access to individual retirement accounts, and those accounts, which I'll call IRAs, is the subject of this episode.
IRAs are a vital component of retirement security in the United States. As of the end of 2025, there are $19.2 trillion dollars invested in these accounts. To put that number in perspective, I was surprised to see that it is nearly double the amount invested in 401k accounts, which have $10.1 trillion. IRAs matter because they can be a useful part of a retirement savings strategy, but the rules vary depending on the type of IRA you choose. Understanding how IRAs work, including who can contribute, how much you can contribute, and how withdrawals or tax can help you decide how they may fit into your broader retirement plan.
Time to dive in. Let's start by defining the IRA.
An IRA or Individual Retirement Account is a tax-advantaged account that can help you save and invest for retirement. Depending on the type of IRA, you may receive a tax benefit either when you contribute or when you withdraw funds. Most IRAs offer a wide selection of investment options, such as individual stocks, bonds, mutual funds, exchange-rated funds or ETFs, and certificates of deposit, also known as CDs. While it is true that an IRA is a retirement account, don't confuse it with a 401k account. Unlike an employer-sponsored retirement plan, such as a 401k, an IRA is generally opened by an individual through a brokerage firm, bank, or other financial institution. Once the account is open, you can add money to your account, choose how to invest it, and potentially benefit from tax advantages based on the type of IRA you choose. Your contributions, investment choices, taxes, and withdrawals are all subject to IRS rules. When I use the term IRA, I'm using it to describe a category of account types. By that I mean there isn't just one type of IRA. That matters because once you've decided an IRA is worth investigating, you've then got to decide which type makes the most sense for your situation. There are two main types of IRAs to consider, traditional IRAs and Roth IRAs. The main difference is when you receive the potential tax benefit. Let me start with traditional IRAs first. Traditional IRAs are generally funded with pre-tax dollars. If your contributions qualify, you can get a tax deduction now, while withdrawals are generally subject to ordinary income tax and retirement. In other words, think of these accounts as tax-deferred accounts, not tax-free accounts. The money that you contribute into the plan isn't taxed now, but under most circumstances, it will be taxed when you pull the money out. Not all contributions to a traditional IRA are tax deductible. Deductibility can depend on your income and whether you or your spouse is covered by an employer-sponsored retirement plan, such as a 401k. Also, be careful when you pull your money out. Traditional IRAs are subject to Required Minimum Distributions, RMDs for short, and early withdrawals may trigger a 10% US federal tax penalty. That's a lot of jargon, but just remember that you generally can't pull the money out prior to age 59.5 and you must start pulling it out at approximately age 73
As for Roth IRAs, these are funded with after-tax dollars so you don't receive an immediate tax deduction. However, qualified withdrawals, generally those made after age 59.5 and after a five-year holding period, are tax free. Not only that, contributions can generally be withdrawn at any time, tax and penalty free. Roth IRAs are not subject to required minimum distributions for you as the original owner of the account, but you must meet IRS income limits to contribute. At this point, a logical question is, well, which one makes sense for me? A key thing for you to think about is when do you expect your tax rate to be higher? If you think your tax rate on withdrawals and retirement may be higher than your marginal tax rate today, a Roth IRA may be worth considering because qualified withdrawals and retirement may be tax free. If you think your tax rate today may be higher than in retirement, a traditional IRA may be more appealing because it may allow you to receive a tax deduction now when you're at the higher rate and may tax us on withdrawals later at the potentially lower rate. If you expect your tax rate to be about the same, the income tax difference may be less significant. In that case, your decision may come down to other factors, such as whether you want a potential tax break now, tax rate qualified withdrawals later, or more tax flexibility in retirement. If you're not sure about your tax rates, keep in mind that this doesn't have to be an all-or-nothing decision. You can split your contributions between accounts. For example, split the difference. Consider 50% contributed to a Roth and 50% to a traditional IRA. Just remember that the combined contribution can't be over the annual contribution limit.