An individual retirement account, or IRA, is a savings account that is used to put away money for retirement, potentially grow funds through investment, and often get tax breaks.
There are a few different types of IRAs, but the two most common are traditional and Roth IRAs. While both types let you contribute up to $6,500 yearly (as of 2023), with an additional catch-up contribution of $1000 for those over age 50, one key difference is the way the two accounts are taxed: Traditional IRAs let you deduct your contributions up front and pay taxes on distributions when you retire, whereas Roth IRA contributions are not tax deductible, but you can withdraw money tax-free in retirement.
For most people, IRAs are worth learning more about—and potentially investing in. This guide offers insight into the different types of IRAs, which one might be right for you, and how to get started with an individual retirement account today.
What Are the Different Types of IRA Accounts?
There are numerous types of IRAs. The two most common types of IRAs are traditional and Roth IRAs. However, if an investor works for themselves or owns a small business, they might also establish a SEP IRA (aka, Simplified Employee Pension) or SIMPLE IRA (aka Savings Incentive Match Plan for Employees). You can check out our IRA FAQs for another broad overview, too.
And to pre-empt your next question: Yes, you can have multiple IRAs! But you cannot exceed the total contribution limits across all the IRAs you hold.
Below is an overview of the most common IRA types:
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A traditional IRA is a retirement account that allows individuals to contribute and invest money pre-tax. Money inside a traditional IRA grows tax-deferred, and it’s only subject to income tax once it gets withdrawn. Money in the account may grow faster than it otherwise might, because the IRS isn’t assessing any taxes while it’s invested.
Contributions to a traditional IRA are typically tax-deductible because the amount you save in a traditional IRA each year can lower an individual’s taxable income in the year they contribute.
Traditional IRAs are subject to contribution limits. In 2023, for example, individuals can contribute up to $6,500 per year to their traditional IRA (or $7,500 if aged 50 or older and making catch-up contributions).
For this sort of account, when individuals reach a certain age, they must start taking required minimum distributions (RMDs). RMDs are generally calculated by taking the IRA account balance and dividing it by a life expectancy factor determined by the IRS.
Saving in an IRA means an individual is, essentially, locking their money up until they reach age 59 ½. Withdrawals from a traditional IRA before then are usually subject to income tax and a 10% early withdrawal penalty. There are some exemptions to this rule, however — such as using a set amount of IRA funds to pay a medical insurance premium after an individual loses their job.
The main difference between a Roth IRA and a traditional IRA is that contributions to a Roth are made with after-tax money, and contributions are not tax-deductible. Nonetheless, invested money can then grow tax-free inside the Roth IRA account and the funds are not, typically, subject to income tax when withdrawals are made after age 59 ½.
Roth IRAs are subject to the same contribution limits as traditional IRAs, but the amount an individual can contribute may be limited based on filing status and income levels, as noted above.
Moreover, Roth beneficiaries are not legally required to withdraw funds at a specific age.
Additionally, Roth withdrawal rules are a bit more flexible than those associated with a traditional IRA. Individuals can withdraw contributions to their Roth IRAs, for example, at any time without having to pay income tax or a penalty free. However, they may pay taxes and a 10% penalty on earnings they withdraw before age 59 ½.
A simplified employee pension or SEP IRA provides small business owners and self-employed people with an easy way to contribute to their employees’ or own retirement plans. Contribution limits are significantly larger than traditional and Roth IRAs.
As of 2023, employers can contribute an amount up to 25% of their employees’ compensations or $66,000 each year, whichever is less. The amount of employee compensation that can be used to calculate the 25% is limited to $330,000 in 2023.
If an individual is the owner of the business and makes contributions for themselves, employee contributions must be the same proportion of their salary. When it comes to RMDs and early withdrawal penalties, SEP IRAs follow the same rules as traditional IRAs. (However, in certain situations, this penalty may be waived).
A Savings Incentive Match Plan for employees, or SIMPLE IRA, is a traditional IRA that both employees and employers can contribute to. They are, typically, available to any small business with 100 employees (or fewer).
Employers are required to contribute to the plan each year by making a 3% matching contribution, or a 2% nonelective contribution, which must be made even if the employee doesn’t contribute anything to the account. This 2% contribution can be calculated on no more than $330,000 of employee compensation.
Employees can contribute up to $15,500 to their SIMPLE IRA in 2023, and they can make catch-up contributions of $3,500 after age 50, if their plan allows it.
As with other traditional IRAs, SIMPLE plans have age-dictated RMDs and early withdrawals are subject to income tax and a 10% penalty. The early withdrawal penalty increases to 25% for withdrawals made during the first two years of participation in a plan. (There are, however, certain exemptions recognized by the IRS that would allow a SIMPLE IRA beneficiary not to pay additional taxes.)
Benefits of Opening an IRA
The basic benefit of opening an IRA is that you are saving money for your future. Investing in retirement is an important financial move at any age. Beyond that, here are some popular benefits of opening an IRA:
• Anyone who earns income can open an IRA. It’s a good option if you don’t have access to an employee-sponsored plan, such as a 401(k) or a 403(b). Non-income earning spouses can also open a spousal IRA.
• An IRA can supplement an employee plan. You could open an IRA to supplement your retirement plan at work, especially if you’ve already contributed the annual maximum.
• An IRA might be a good rollover vehicle. If you’re leaving your job, you could roll over funds from a 401(k) or 403(b) into an IRA. That may give you access to better investment options—not to mention consolidate all your accounts in one place.
• A SEP IRA might he useful if you’re self-employed. A SEP IRA may allow you to contribute more each year than the Roth or Traditional IRAs, depending on how much you earn.
Which Type of IRA Works for You?
There are many different types of IRAs and deciding which one is better for your particular financial landscape will depend on your individual circumstances and future plans. Here are some questions to ask yourself when deciding between different types of IRAs:
• Are you looking for a way to pass tax-free assets to your family? If so, a Roth IRA might be more attractive to you.
• Thinking ahead, what do you expect your tax income bracket to look like at retirement? If you think you’ll be in a lower bracket at retirement, it might make more sense to invest in a traditional IRA, since you’ll pay more in taxes today than you would when you withdraw it later.
• Will you likely be at a higher tax bracket at retirement? That can easily happen as your career and income grow and you experience lifestyle inflation. In that case, a Roth IRA might give you the opportunity to save on taxes in the long run.
How Much Should You Contribute to an IRA?
If you can afford it, you could contribute up to the maximum limit in your IRA every year (including catch-up contributions if you qualify). Otherwise, it generally makes sense to contribute as much as you can, on a regular basis, so that it becomes a habit.
Until you’re well on track for retirement, many financial professionals recommend prioritizing IRA contributions over other big expenses, like saving for a down payment on a first or second home, or for your kids’ college education.
Any money you put away has the opportunity to grow over time, thanks to compound interest. Of course, everyone’s circumstances are different, so for specifics unique to your situation, it might help to talk to a financial advisor and/or a tax advisor.
How Can You Use IRA Funds?
Early withdrawals of your IRA funds, prior to the age of 59.5, can trigger a 10% penalty tax. However, there are exceptions. There are some ways an individual can use their IRA funds before hitting the age eligibility and without facing the 10% penalty, according to IRS rules, though early withdrawals are generally considered last resorts after all other options have been exhausted. These ways include:
• Permanent disability
• Higher education expenses
• Out-of-pocket medical expenses totaling more than 10% of adjusted gross income
• Qualified first-time homebuyers up to $10,000
• Health insurance premiums while unemployed
• IRS levy of the plan
• Military reservist called to duty
• Death of IRA’s owner
IRAs offer individuals an opportunity to save money for retirement in a tax-advantaged plan, without relying on an employer-sponsored plan like a 401(k). In addition, with a few different types of IRAs to choose from, it’s likely that many people will find an account that fits with their needs and goals.
IRAs are available from a wide range of investment brokerages, and typically you can choose between totally DIY options and automated investment products that can help you meet your retirement goals at a minimum effort.
SoFi Invest® offers traditional and Roth IRAs. For individuals who want to make investments in addition to their retirement accounts, SoFi also offers an Active Investing platform, where investors can buy stocks, ETFs or fractional shares. For a limited time, funding an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is open and fund a SoFi Invest account.
How is an IRA different from a 401(k)?
Both IRAs and 401(k)s are tax-advantaged ways to grow money for retirement, but whereas a 401(k) is an employer-sponsored plan that is offered through a person’s job, an IRA is an account you can open on your own.
What’s the difference between a Roth IRA and a Traditional IRA?
The biggest difference in a traditional vs. Roth IRA is when your money is taxed. With a traditional IRA, you get a tax deduction when you contribute money—so the money going into your account is tax free, and when you withdraw it in retirement, it will be taxed.
With a Roth IRA, you don’t get a tax deduction when you contribute but your money grows tax-free—meaning that when you withdraw it in retirement, you won’t pay taxes on the withdrawals.
When should I make IRA contributions?
One simple way to fund your IRA is to set up an automatic contribution once a month that takes money from your checking or savings account and puts it directly into your IRA. You don’t have to contribute monthly—the frequency is totally up to you, and many people contribute once annually, after they receive a year-end bonus, for example, or before the annual deadline of when taxes are due in April of the following year.
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