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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 (IRA) 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.
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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IRAs have rules about how money can be deposited and withdrawn.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 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.
Did you know?
In 2023, the contribution limit for all of your traditional IRAs and Roth IRAs is $6,500 (or $7,500 if you’re age 50 or older).
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.
Traditional
Roth
SIMPLE
SEP
Best for
Individuals
Individuals
Small businesses with 100 or fewer employees
Freelancers 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-advantage
Tax-deductible contributions
Tax-free distributions
Tax-deductible contributions
Tax-deductible contributions
How to open an IRA
Ready to open your own IRA? Here’s a quick look at the process:
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.
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.
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).
Select your assets. Funding your IRA is one thing, investing your money is another. Once you’ve contributed to your IRA, choose the stocks, bonds, ETFs or any other assets made available by your broker that you want to invest in. You can hold a wide variety of securities in an IRA, with the exception of derivatives contracts. The ideal assets for your account will depend on your time horizon and risk tolerance.
Establish a contribution schedule. Consider setting up regular contributions to your IRA with scheduled bank transfers on a monthly, quarterly or annual basis.
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Finder is not an adviser or brokerage service. Information on this page is for educational purposes only and not a recommendation to invest with any one company, trade specific stocks or fund specific investments. All editorial opinions are our own.
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
Bottom line
Each type of IRA offers a distinct path to tax-advantaged wealth building. Before you open an IRA, review your retirement investment options with multiple brokers to find the account that’s best equipped to serve your ongoing investment needs.
Frequently asked questions
As many as you'd like. In fact, there's no limit to the number of IRAs you can hold. But doubling down on your IRA count doesn't necessarily mean you can increase your contributions. Your annual contribution limit will remain the same no matter how many accounts you hold.
Yes. An IRA is an investment account and any investment is subject to risk.
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Shannon Terrell is a lead writer and spokesperson at NerdWallet and a former editor at Finder, specializing in personal finance. Her writing and analysis on investing and banking has been featured in Bloomberg, Global News, Yahoo Finance, GoBankingRates and Black Enterprise. She holds a bachelor’s degree in communications and English literature from the University of Toronto Mississauga.
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