An IRA is a retirement savings account that operates similarly to a 401(k). It provides tax advantages to help you save for retirement. However, the difference is that it is not employer-sponsored.
There are many different "types" of IRAs. However, the most common for individuals are traditional and Roth. Traditional IRAs are comprised of pre-tax contributions. Roth IRAs accept after-tax contributions.
Technically, you can have both an IRA and a 401(k) account. As long as you make earned income, you can open an IRA.
What is an IRA and how does it work?
An individual retirement account (IRA), like a 401(k), is a type of retirement savings account with tax advantages. When opening an IRA, individuals can invest in various financial instruments such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds. The point of an IRA is that as you contribute to your account over time, you should see growth in your funds with the power of compound interest.
Anyone with earned income that meets income restrictions—even those with an existing 401(k) through an employer—can open an IRA. Earned income does not include proceeds from investments, interests, gambling, and other sources of money that are not work-related. The sole restriction lies in the annual aggregate limit for contributions to retirement accounts (more on this below).
What are the different types of IRA accounts?
The most common IRAs include:
The tax advantages for an IRA depend on what “type” of IRA you have. For most individuals who are not employers or small business owners, you’ll primarily be concerned with three types of IRAs: traditional, Roth, and rollover.
With traditional IRAs, you contribute pre-tax money, and your investment gains are tax-deferred. That means the income you contribute towards an IRA can reduce your annual taxable income. Then, when it comes time to withdraw money for retirement, your withdrawals will be taxed at the ordinary income tax rate. The IRS states that you must be at least 59 1/2 to withdraw money without incurring a 10% penalty.
Traditional IRAs also have a required minimum distribution (RMD). An RMD means that when you turn 73 years old, you are legally required to withdraw a certain amount according to various factors.
A traditional IRA can be a better option if you’re planning for your retirement income to be lower during retirement or if you’re a qualifying high earner and want to avoid paying your current high marginal tax rate.
With a Roth IRA, your contributions are taxed upfront, allowing you to withdraw money from it tax-free. The downside to a Roth IRA is that making contributions doesn’t lower your taxable income. However, the money that does “grow” in the account won’t be taxed if you meet certain requirements when it comes time for you to make a withdrawal.
Unlike a traditional IRA, a Roth IRA does not have any RMDs, which means you aren’t required to withdraw, no matter what age you are. A Roth IRA can make the most sense if you think you’ll be in a higher tax bracket during retirement.
When you leave an employer that sponsors your 401(k) plan, you can transfer your money into an IRA, otherwise known as “rollover”. It is also common for employers to move funds (absent of consent) from a former employee’s 401(k) into an IRA as well (however, this is only permissible if the balance in your 401(k) account is under $7,000).
In either case, there are a few advantages of why opening a rollover IRA can be beneficial. These reasons include:
Depending on your employer’s investment offerings, investments can be cheaper
Lower account fees
Simple to use because if your current 401(k) plan does not accept rollovers. With a rollover IRA you can consolidate several retirement accounts which can uncomplicate your retirement planning
The disadvantage of a rollover IRA is that there is a contribution limit. If you are planning on contributing, IRAs have a maximum contribution limit of $7,000, which is significantly lower than a 401(k). Additionally, you cannot borrow a loan against your IRA, which is something you can do with a 401(k).
The process of rolling over your contributions from a 401(k) account to an IRA depends on what type of IRA you want to open and the financial institution you select, which we’ll expand on below.
A SIMPLE IRA is a retirement savings plan designed for small businesses with fewer than 100 employees. It’s generally considered more affordable than the costs of a conventional retirement plan. Contributions are made of pre-tax money because after-tax deferrals are not allowed. Employers must contribute a match of 100% up to 3% of your compensation or a 2% nonelective contribution for each eligible employee.
What is a nonelective contribution?
Nonelective contribution means that even if an employee doesn’t contribute to their SIMPLE IRA, the employer must still contribute 2% of their compensation to the plan (up to the contribution limit).
The disadvantage of a SIMPLE IRA is that the contribution limits are lower than a 401(k). For 2024, the contribution limit for a SIMPLE IRA is $16,000 for individuals under 50. Employees can also not take loans from a SIMPLE IRA—which may be a concern if you have emergency circumstances.
A simplified employee pension (SEP) plan is a retirement plan that allows employers to contribute up to 25% of net income or a maximum of $69,000 for 2024. The advantages of the SEP IRA are that it is easy to set up, has low administrative costs, and allows for flexible annual contributions, which means that the contribution rate can change yearly. A SEP IRA can be ideal for businesses that experience seasonal cash flow issues.
The disadvantage of the SEP IRA is that it may be costly as your business grows. If you give yourself a contribution, you must make the same contribution (as a percentage of compensation) to all eligible employees.
Solo 401(k)s may be a better option
If you are self-employed or a solo business owner, consider exploring the solo 401(k), otherwise known as the solo(k). The primary difference between the SEP IRA and the solo 401(k) is that the business owner can contribute “more”, especially if you are over the age of 50.
With a solo 401(k), you can defer up to $23,000 and make an employer contribution of up to 25% of the business income (for 2024, you can also make a catch-up deferral of up to $7,500). That means the maximum you can contribute is $69,000, and $76,500 if you are over the age of 50. You can even save more money on business taxes with that employer contribution.
Is it better to have a 401(k) or IRA?
The short answer is that it depends. Individuals with a 401(k) can also have an IRA. In fact, it is possible to max out both your 401(k) and your IRA, if you so choose. However, if you have the option of investing in one or the other, it may be more advisable to contribute to your 401(k), especially if your employer offers a matching contribution. A 401(k) also has a higher contribution limit than an IRA.
What are the differences between a traditional 401(k) and an IRA?
An IRA works similarly to a 401(k), with a few key differences. The first is that unlike a 401(k), contributions to your IRA account are not made through payroll deductions. The second difference is that an IRA has a lower contribution limit than a 401(k). For 2024, the contribution limit for an IRA is $7,000 for those 50 and under and $8,000 for those over 50. In comparison, the 401(k) contribution limit for 2024 is $23,000, and the catch-up contribution for those 50 and older is $7,500. However, the contribution limit does not apply to rollover contributions.
A 401(k) may also have much less investment options than an IRA. An IRA will allow you to invest in many different types of funds. Lastly, a 401(k) has limited distribution circumstances. An IRA, on the other hand, does not have limitations.
How to open an IRA account
Opening an IRA is a relatively straightforward process similar to applying for other retirement savings accounts. Learn how to select and open an IRA that best suits your needs.
Step 1. Choose Roth or Traditional
For most individuals, you’ll want to decide if you wish to open a traditional IRA or a Roth IRA. The decision is ultimately up to you–if you don’t have access to an employer-sponsored 401(k), a traditional IRA might be a better option because you can make pre-tax contributions. But on the other hand, a traditional IRA might not be deductible if you exceed certain qualifications like income, and if you are already covered by a retirement plan.
On the other hand, a Roth IRA might be a better option if you think you’ll be in a higher tax bracket during retirement and won’t have to pay any taxes on your withdrawals (if you meet certain requirements). However, keep in mind that a Roth IRA has annual adjusted gross income limitations. For example, according to the IRS, if you are married, but your modified annual adjusted gross income is between $218,000 to $228,000, you can only contribute a reduced amount.
Step 2. Compare providers
If you consider yourself a more passive investor, or someone who generally doesn’t want to do the work involved with balancing your portfolios, choosing investments, and managing your retirement savings, you may want to consider providers that automate most of the work involved with retirement investing. Some IRA and 401(k) providers, like Human Interest, use technology that can help you select investments according to age, risk tolerance, and costs. This can be a better option if you want to avoid manually selecting your funds and deciding what percentage you want to invest.
After deciding your investing style, you’ll want to look closely at the fees from each IRA provider. The most important fees you’ll want to pay close attention to are transaction fees, account maintenance fees, and mutual fund fees.
You can find most of these fees in your IRA provider’s annual summary statement. Generally, the most common IRA fees are account maintenance fees, custodial fees, transaction fees, expense ratio fees, and sales load fees. Note that it can be difficult to find these fees unless you carefully look through your transaction activity.
Step 3. Fill out the application
Most financial institutions, banks, brokerages, and mutual fund companies allow you to apply for an IRA online. They’ll ask you for basic personal and banking information. Your provider may ask you to provide:
Your full name
Date of birth
Social security number
Driver’s license or passport
Step 4. Start contributing
Once your IRA is ready to go, it’s time to start contributing. The contribution limit for a traditional IRA for 2024 is $7,000 for individuals under 50. For those over 50, the catch-up contribution remains at an additional $1,000. How much you choose to contribute is up to your personal financial goals. If you want to start saving for retirement more aggressively, you may find more success maxing out your IRA contributions.
Open an IRA with Human Interest
An IRA can provide greater flexibility to achieve your retirement goals and comes with tax benefits. Because an IRA isn’t employer-sponsored, as long as you have earned income, just about anyone can open an IRA. At Human Interest, we offer both traditional and Roth IRAs. With our online application, you can set up an IRA in minutes. Apply for an IRA today.
Article ByZoe Weisner
Zoe Weisner is a content marketing manager at Human Interest. Zoe has spent the majority of her career in the B2B fintech space, with half a decade of experience writing content about small business, banking, and personal finance.