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A beginner-friendly guide to IRAs

Tax advantages abound, but watch for contribution limits and withdrawal penalties.

An individual retirement account (IRA) can be a powerful ally on the path to building your retirement nest egg. But not all IRAs are made equal. The right IRA for your investment needs will depend on your income trajectory and savings goals.

What is an IRA?

An individual retirement account is an investment account designed to help you save for retirement. You can open an IRA at a bank or with an online broker and can use your account to invest in stocks, bonds, ETFs or other securities.

There are a variety of IRAs to choose from, including traditional, Roth, SIMPLE and SEP IRAs. Each account is bound by a unique set of rules, like how much you’re allowed to contribute annually and how account deposits and distributions are taxed.

How do IRAs work?

IRAs have rules about how money can be deposited and withdrawn. Annual contribution limits set a cap on how much you can invest each year. And you may be slapped with a withdrawal penalty of up to 10% for pulling funds from your account before the age of 59½.

IRAs also offer tax-advantages depending on the type of account you open. Traditional IRAs let you make tax-deductible contributions. Roth IRAs let you withdraw funds tax-free.

You can open an IRA at a bank or with an online broker, but be aware that banks may limit your investment options to set assets, like certificates of deposit or savings accounts. Online brokers tend to offer more portfolio flexibility, allowing you to invest in stocks, bonds, mutual funds, ETFs — even real estate, in some cases. But don’t expect to see derivatives on the bill: most IRAs don’t offer them.

Types of IRAs

Individual retirement accounts come in four distinct flavors.

Traditional

Contributions made to traditional IRAs are typically tax-deductible. This means if you deposit $1,000 into your traditional IRA, your taxable income for the year drops by $1,000. The downside? All withdrawals made from a traditional IRA are subject to tax. And if you make a withdrawal from your traditional IRA before the age of 59½, you’ll pay a 10% withdrawal penalty.

Annual contribution limits for traditional IRAs in 2021 are $6,000 per account — but if you’re over 50, you can contribute up to $7,000 through catch-up contributions.

Roth

Unlike traditional IRAs, Roth IRA contributions are not tax deductible — anything you deposit into your Roth IRA will still count toward your annual income once tax season rolls around. But Roth IRAs offer a different type of tax advantage: Withdrawals are tax-free and you don’t pay tax on capital gains. Plus, early withdrawals from Roth IRAs aren’t subject to an early withdrawal penalty.

The same contribution limits that govern traditional IRAs also apply to Roth IRAs: $6,000 per account unless you’re over 50, in which case you can contribute up to $7,000.

SIMPLE

Savings Incentive Match Plan for Employees IRAs are employer-sponsored retirement accounts — and quite the mouthful. They’re typically offered by small businesses with 100 or fewer employees. SIMPLE IRA contributions are similar to traditional IRA contributions in that they’re tax-deferred and reduce your annual taxable income. And like traditional IRAs, funds are taxed upon account withdrawal.

Employer contributions are mandatory, which means your employer must match what you contribute to your account up to 3% of your pay. Contribution limits apply to SIMPLE IRAs, but are higher than the caps on traditional and Roth IRAs. In 2021, annual contribution limits for SIMPLE IRAs are $13,500 per account — but if you’re over the age of 50, you can contribute as much as $16,500 through catch-up contributions.

SEP

A Simplified Employee Pension Plan, or SEP IRA, is a retirement account for self-employed individuals. They work like traditional IRAs: tax-deferred gains and tax-deductible contributions. The difference lies in the contribution limits. In 2021, contribution limits for SEP IRAs sit at $58,000 or 25% of compensation — whichever is less.

To set up a SEP IRA, you must be a sole proprietor or belong to a partnership or corporation.

IRAs at a glance

To sum up, here’s an overview of the differences that separate traditional, Roth, SIMPLE and SEP IRAs.

TraditionalRothSIMPLESEP
Best forIndividualsIndividualsSmall businesses with 100 or fewer employeesFreelancers and self-employed individuals
Contribution limits$6,000 per account ($7,000 if you’re over 50)$6,000 per account ($7,000 if you’re over 50)$13,500 per account ($16,500 if you’re over 50)The lesser of $58,000 or 25% of compensation
Tax-advantageTax-deductible contributionsTax-free distributionsTax-deductible contributionsTax-deductible contributions

How to open an IRA

Ready to open your own IRA? Here’s a quick look at the process:

  1. Choose a broker. Explore your brokerage options across banks, robo-advisors and online trading platforms. Take a close look at commission fees, asset options and service reliability to start narrowing down your choices.
  2. Complete your application. Once you’ve found a broker you like, you’ll need to fill out an account application. Be prepared to supply some personal information, photo ID and your Social Security number. You’ll also need to connect an external account to fund your IRA.
  3. Fund your account. To complete the application process, you’ll need to fund your IRA. This can be done by bank transfer or by rolling over an existing account, like a 401(k).
  4. Select your assets. Fill your investment portfolio with stocks, bonds, ETFs — anything you like, really. You can hold a wide variety of securities in an IRA, with the exception of derivatives contractors. The ideal assets for your account will depend on your time horizon and risk tolerance.
  5. Establish a contribution schedule. Consider setting up regular contributions to your IRA with scheduled bank transfers on a monthly, quarterly or annual basis.

Compare retirement accounts

Name Product Minimum deposit to open Annual fee Available asset types
SoFi automated investing
$1
0%
Stocks, ETFs
Put your money to work. Let SoFi build and manage a portfolio for you. Pay zero SoFi management fees.
Webull
$0
0%
Stocks, Options, ETFs
Margin financing rates start at 3.99%. No monthly subscription fees for margin.
TradeStation
$2,000
$0 per month
Stocks, Bonds, Options, Mutual funds, ETFs, Cryptocurrency
A platform built for all kinds of traders and all styles of trading
Blooom
$0
$45 per year
Stocks, Bonds
After an analysis, Blooom will place the trades within your 401k, 403b, 401a, 457 or TSP plan account for a low flat fee.
Stash Invest
$0.01
$1 per month
Stocks, ETFs
Stash is more than an investment app. You’ll have access to tools that can help you become a confident investor.
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Compare up to 4 providers

IRA fees

Fees can eat into profits and detract from your retirement nest egg. Before you open an IRA, be prepared to encounter one or more of the following fees:

  • Account maintenance fees. Some brokers charge annual maintenance fees of up to $50, so review the fine print before you sign up.
  • Trading commissions. Many platforms have done away with stock commissions, but you may still encounter trading fees when swapping bonds or other assets.
  • Expense ratios. Exchange-traded funds and mutual funds carry expense ratios: a percentage-based fee that helps cover the cost of operating the fund. Expect to pay an expense ratio of 0.2% to 1.5% when you invest in mutual funds and ETFs.

IRA vs. 401(k): What’s the difference?

Both 401(k)s and IRAs are tax-advantaged investment accounts designed to help you invest for retirement. The main difference? 401(k)s are only offered by employers while traditional and Roth IRAs can be opened by any qualifying individual at a bank or online brokerage.

SEP and SIMPLE IRAs are similar to 401(k)s in that they’re all employer-sponsored retirement accounts. But SEP and SIMPLE IRAs are designed for small business owners and the self-employed, while 401(k)s are offered by larger, well-established employers to their employees.

Keep in mind that when it comes to 401(k)s versus IRAs, it’s not necessarily one or the other. It’s absolutely possible to have both. In fact, numerous investors open IRAs after maxing out their 401(k)s.

Pros and cons

Pros

  • Tax-advantaged. From tax-deferred contributions to tax-free withdrawals, IRAs allow you to direct how and when your investments are taxed.
  • Self-directed. Unlike the contents of a 401(k), you’re in complete control over the investment strategy of your IRA.
  • Investment selection. IRAs typically allow for a wide range of investment classes, including stocks, bonds, mutual funds, ETFs and more.

Cons

  • Contribution limits. No matter what type of IRA you hold, your contributions will be capped at the annual limit set by the IRS.
  • Withdrawal penalties. If you pull funds from your IRA before the age of 59½, you’ll face a 10% early withdrawal penalty.

Can I avoid an early withdrawal penalty?

Yes, there are a handful of circumstances in which you can withdraw funds from your traditional IRA ahead of schedule and avoid the 10% withdrawal penalty, including:

  • To cover unreimbursed medical expenses
  • To cover health insurance premiums while unemployed
  • To cover higher education expenses
  • To cover the cost of buying, building or rebuilding a home
  • You’re called to active duty
  • You become permanently disabled
  • You inherit an IRA
  • You plan to withdraw substantially equal periodic payments
  • The IRS levies the funds directly
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

Each type of IRA offers a distinct path to tax-advantaged wealth building. Before you open an IRA, review your retirement account options with multiple brokers to find the account that’s best equipped to serve your ongoing investment needs.

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