Those who value investment flexibility will enjoy the benefits that come with an IRA.
If you went around asking people to name a retirement account, there’s a good chance that most of them would say 401(k). Based on its popularity, you could argue that it’s the retirement account. According to the latest U.S. Census data, over 34% of working-age people (15 to 64 years old) owned a 401(k).
Despite its popularity and how effective a 401(k) can be at saving for retirement, there’s another retirement account that I’d prioritize before focusing all my attention on a 401(k): an IRA.
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The main difference between the two types of IRAs
A great thing about IRAs is they aren’t tied to employers, so anyone with earned income can open one. It’s a simple process that you can complete online in most cases.
The main types of IRAs are Roth and traditional. They each share common benefits but have noteworthy tax-break differences.
You contribute after-tax money into a Roth IRA, and in turn, you get to take tax-free withdrawals in retirement. This allows your money to grow and compound without a tax bill waiting for you down the road.
The traditional IRA’s tax break is similar to a 401(k) because contributions are pre-tax. In the case of a traditional IRA, your contributions can be tax deductible, depending on your income, filing status, and whether you’re covered by a work-sponsored retirement plan (like a 401(k)).
It’s worth noting that IRAs have much lower contribution limits than 401(k)s. The most you can contribute to an IRA — both Roth and traditional combined — in 2024 is $7,000, or $8,000 if you’re 50 or older. This relatively low-contribution limit makes it easier to prioritize and max out before returning full focus to your 401(k) contributions.
Don’t underestimate the importance of flexibility
One of the main reasons you should lean into an IRA is the freedom to choose whatever you want to invest in.
With a 401(k), your plan administrator provides you with investment options, and those are your only choices. For people who prefer a hands-off approach, that could be a good thing. However, for people who want to be able to tailor their investments to fit their personal situation, this may not always be possible with a 401(k).
Imagine you’re excited about AI’s long-term potential and want to dedicate a portion of your portfolio to companies leading the charge on the technology. Adding those individual companies to your 401(k) wouldn’t be an option unless they’re your employer, and you likely couldn’t add an industry-specific ETF, either.
Flexibility for life events, not just emergencies
Life has a way of throwing curveballs, and sometimes, the only way to financially deal with them is by tapping into your retirement funds. In most cases, withdrawing early from a retirement account will incur a 10% early-withdrawal fee, but an IRA offers a handful of exceptions to this rule.
Money from an IRA can be used for health insurance premiums while you’re unemployed or unreimbursed medical expenses over a certain amount, but it doesn’t have to be a negative situation to avoid the early-withdrawal fee.
You can also use IRA funds to put toward your first house purchase (up to $10,000), qualified higher education expenses (like tuition, books, and other student fees), and qualified birth or adoption expenses (up to $5,000).
What type of IRA account is right for you?
Choosing between a Roth and a traditional IRA isn’t always straightforward. However, to simplify the decision, you should ask yourself when you want to pay taxes.
If you expect your tax bracket to be higher around retirement, you should consider a Roth IRA. This allows you to pay taxes now when your tax bracket is lower and then have tax-free withdrawals when you may be in a higher bracket down the road.
If you’re in your peak earning years, you should consider a traditional IRA. You can get your tax break upfront when you’re in a higher bracket and then pay taxes when you’re likely in a lower bracket in retirement.
There’s also the income limit with Roth IRAs. The most you can earn and contribute to a Roth IRA is $161,000 if you’re single and $240,000 if you’re married and filing jointly. If you’re over that threshold, your decision is already made for you: Go with a traditional IRA.
In either case, opening and contributing to an IRA can pay off greatly in retirement. When you’re enjoying your retirement years without finances being an issue, you’ll almost certainly look back and be glad you did.