Opening an IRA is a great way to save for retirement. It can operate as your primary investment vehicle or work in tandem with other popular retirement accounts, such as employer-sponsored 401(k)s.  

There are several types of IRAs available to investors, and understanding the key features and benefits of both will ensure you choose the right one for your long-term savings goals. 

Here’s everything you need to know about the types of IRAs available to you and which one may be the best suited for your needs. 

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What Is an IRA?

An Individual Retirement Account, or IRA, is a tax-advantaged savings account used to amass savings over a long period — ideally until you hit retirement age. Each year, you can contribute funds up to the limits determined by the IRS. After that, funds in your account grow on a tax-deferred or tax-free basis, depending on the type of IRA you choose.   

 

 

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5 Types of IRAs Explained

There are five common types of IRAs to choose from.  Some, like traditional IRAs, are available to nearly everyone who has an earned income, while others, like SEP IRAs, are available under certain circumstances. Here’s what you need to know about each. 

1. Traditional IRA

A traditional IRA is a tax-deferred retirement account. That means traditional IRA contributions are made with pre-tax dollars, and you pay taxes when you withdraw funds from the account in retirement, often known as a distribution.  

Anyone with a taxable income can contribute to an IRA, and there are no income limits that would prevent you from contributing to an IRA. Taxes are based on the tax bracket you’re in when you take distributions, which means it may be a better option if you expect to be in a lower tax bracket when you retire. 

With a traditional IRA, you can invest in common securities, such as stocks, bonds, CDs, mutual funds, and ETFs. 

Key characteristics:

  • Tax structure: Tax-deferred
  • Contribution limit: $6,500, or $7,500 if you’re 50 or older (2023). 
  • Income limits: None. 
  • Income requirements: Must have taxable compensation. 

2. Roth IRA

A Roth IRA allows for tax-free growth and withdrawals. That’s because you contribute to a Roth IRA using after-tax dollars. That makes it a good option if you think you’ll be in a higher tax bracket when you retire. 

Like traditional IRAs, you must have a taxable income to contribute, but there are additional income-based rules that determine if you’re eligible to make contributions. IRS Roth contribution limits depend on your income and tax-filing status.  

For instance, if you’re married and filing jointly, you can contribute up to the annual limit as long as you make $218,000 or less. If you exceed that amount, your maximum contribution is decreased. On the other hand, if you’re married and filing separately, and you make $10,000 or more, you cannot contribute to a Roth IRA.  

If you’re considering or already have a Roth IRA, it’s important to take note of the most current contribution limits as they relate to your tax-filing status and income. 

Like a traditional IRA, Roth IRAs allow you to invest in common securities such as stocks, bonds, CDs, mutual funds, and ETFs.

Key characteristics

  • Tax structure: Tax-free
  • Contribution limit: $6,500, or $7,500 if you’re 50 or older (2023). 
  • Income limits: Based on your tax-filing status. 
  • Income requirements: Must have taxable compensation. 

3. SEP IRA

A simplified employee pension plan (SEP) is a type of traditional IRA (tax-deferred) that caters to small business owners, sole proprietors, and other self-employed individuals, such as freelancers and gig workers. A distinguishing feature of this account is that it allows business owners to open accounts for their employees, though the employees cannot contribute to their accounts.

SEPs are easy to administer and have lower fees when compared to 401(k)s.  They also allow for increased contributions and tax benefits compared to a traditional or Roth IRA. That’s because you can contribute as both the employer and the employee.

Key Characteristics

  • Tax structure: Tax-deferred
  • Contribution limit: Lesser of $66,000 or 25% of compensation. 
  • Income limits: None 
  • Income requirements: Must have taxable compensation

4. SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small business owners and their employees. Like a SEP, a SIMPLE IRA is easy to administer and allows employers to open IRAs for their employers. However, there is an important difference: Both the employer and the employee can contribute to the employee’s SIMPLE account.  

Key Characteristics

  • Tax structure: Tax-deferred
  • Contribution limit: $15,500, or $19,000 if you’re 50 or older. 
  • Income limits: None
  • Income requirements: Employees must have at least $5,000 in earned income.

5. Self-Directed IRA

A self-directed IRA (SDIRA) is a specific type of retirement account that expands investment options to include less common assets, such as real estate, promissory notes, mortgage notes, precious metals, livestock, cryptocurrency, and private equity. 

When you open an SDIRA, you must choose a custodian who will oversee the administrative portion of your account, not the actual investments. Investment decisions are left to you, the account holder, meaning you must perform due diligence for each investment.

SDIRAs are available in multiple forms, including Traditional and Roth structures, as well as SEP and SIMPLE accounts, giving you even more control over how you save for retirement.  

Key characteristics

  • Tax structure: Depends on the type of IRA.
  • Contribution limit: Depends on the type of IRA.
  • Income limits: Depends on account type 
  • Income requirements: Must have taxable compensation
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Which IRA Is Right for Me?

The best way to determine which IRA is right for you is to examine your income, tax-filing status, and retirement goals. Because SEP and SIMPLE IRAs cater to small business owners and the self-employed, it’s also wise to consider your professional status. 

A traditional IRA may be a good option if you expect to be in a lower tax bracket when you retire or if your income and tax-filing status prevent you from leveraging a Roth IRA. 

A Roth IRA is often preferred if you expect to be in a higher tax bracket when you retire since contributions are made with after-tax dollars, meaning you won’t be taxed when you make qualified withdrawals. 

Self-directed IRAs offer the most freedom and flexibility of any account if that is something you desire out of your portfolio. 

If you’re not sure what type of IRA is right for you, speaking to a financial expert, like those with Horizon Trust, can help you make the best choice. 

Understanding Rollovers

When deciding on a new IRA, you’re going to need to roll over any existing retirement funds into your new account. 

A rollover is when you move funds from one retirement plan to another and is a common way for IRA holders to fund their accounts. For instance, if you have a traditional IRA and decide you want to open an SDIRA, you can use a rollover to move funds from the traditional IRA to the new SDIRA account. 

You can also use a rollover to move a self-directed 401(k) after you’ve parted ways with your employer.

There are two types of rollovers: Direct and indirect. 

A direct rollover occurs when funds are moved “directly” from one retirement account to another. The funds are never in your hands and instead move from plan to plan, either from within one financial entity or from one entity to another. 

An indirect rollover, also known as a 60-day rollover, is when the account holder receives the funds from one plan and then deposits them into another, often by check or wire. 

If you choose an indirect rollover, you’ll take possession of the funds and will have 60 days to deposit them into another tax-advantaged retirement account. If you don’t, it’s considered a distribution and will be taxed or penalized based on your age and the type of account you had (i.e., a Traditional or Roth IRA). 

How to Set Up an IRA

Opening an IRA is easy and can often be done in as little as one day. Though the exact procedure can vary based on the type of IRA you want to open and the financial institution you choose, you can typically follow these steps. 

  1. Decide what type of IRA you want to open. Evaluate your current and long-term financial goals as well as the benefits and distinguishing features of each IRA account to determine which one is best suited for your needs. 
  2. Choose the financial institution you want to maintain your IRA account. Options can include a bank, brokerage firm, trust, or custodian. As you review your options, be sure to consider fees, services offered, and the type of IRA you want to open. For instance, most banks don’t offer SDIRAs, so you’ll need to work with a custodian like Horizon Trust. 
  3. Open the IRA account. You can often open an IRA online, though the exact process will vary. To open the account, you’ll likely need 
    • Government-issued ID
    • Personal information such as your social security number, birthdate, phone number, and address
    • Information about your beneficiary or who will inherit your account when you die. 
    • Banking information or account information if you choose to fund your account with a rollover from another retirement plan. 
  4. Fund your account. You can fund your account using funds from an existing checking or savings account. You can also fund your new account using a rollover to move money from an existing tax-advantaged retirement account. 

FAQs

Is an IRA better than a 401(k)?

An IRA is a good option if you’re self-employed or are a business owner who does not have access to an employer-sponsored 401(k). It’s also a good option if you do have a 401(k) but have maxed out your contributions and want another way to save for retirement.

401(k)s have higher contribution limits, however, so if one is available to you, it’s wise to consider it. 

 If you’re unsure which is right for you, speak to a financial advisor who can help you identify the pros and cons of each as they relate to your unique situation. 

What are the downsides of an IRA?

Compared to other retirement plans, especially 401(k)s, IRAs have significantly lower contribution limits.  In addition, if you have a Roth IRA, you may be subject to lower contribution limits depending on your tax-filing status and income. 

Another potential downside is that you cannot take a loan from your IRA, though that option is available under some other retirement plans, such as a 401(k). 

What is the safest investment to make with an IRA?

The safest IRA investment options typically include Treasury bills, CDs, savings bonds, and money market funds. Though no investment is entirely risk-free, investment experts usually consider these options to be far less volatile when compared to other assets, such as stocks, ETFs, or alternative assets like cryptocurrency.