The main types of IRAs and who they're built for

There are four IRA types that most people encounter: the Traditional IRA, the Roth IRA, the SEP IRA, and the SIMPLE IRA. The first two are available to almost anyone with earned income. The last two are designed for self-employed people and small business owners. The core difference between them is when you pay taxes on the money—before you put it in, or after you take it out—and how much you can contribute each year.

Your choice depends on three things: whether you have your own business, what your income is right now, and whether you think you'll be in a higher or lower tax bracket when you retire. This matters because it determines whether you want to reduce your taxes today or in retirement.

Key Takeaways

  • Traditional IRAs let you deduct contributions from your taxes now, but you pay income tax on withdrawals in retirement.
  • Roth IRAs take after-tax money now, but withdrawals in retirement are tax-free, and there are no required withdrawals at any age.
  • SEP IRAs and SIMPLE IRAs are for self-employed people and small business owners, and they allow much larger annual contributions than Traditional or Roth IRAs.
  • Contribution limits change each year and depend on your age and income, so you should check the current year's limits before depositing.
  • You can have more than one IRA at the same time, but your total contributions across all Traditional and Roth IRAs cannot exceed the annual limit.

Traditional IRA: Tax deduction now, taxes later

A Traditional IRA lets you deduct your contribution from your income taxes in the year you make it. If you contribute $5,000 to a Traditional IRA, you can reduce your taxable income by $5,000 that year. You pay no taxes on the money while it sits in the account and grows. When you withdraw money in retirement, you pay income tax on the full amount you take out.

There is a catch: if you or your spouse have a workplace retirement plan (like a 401(k)), your ability to deduct a Traditional IRA contribution phases out at higher incomes. The income limits change every year. If you don't have a workplace plan, you can always deduct the full contribution, no matter how much you earn.

You must start taking withdrawals at age 73 (as of 2023; this age changes based on federal law). These are called required minimum distributions, or RMDs. The IRS calculates how much you must withdraw each year based on your age and account balance. If you don't take the full amount, you owe a penalty on the shortfall.

Roth IRA: No tax deduction now, tax-free withdrawals later

A Roth IRA works backward. You contribute money that you've already paid income tax on—no deduction today. The money grows tax-free inside the account. When you withdraw in retirement, you owe no income tax on any of it, including the growth.

Roth IRAs have income limits too. If your income is above a certain threshold, you cannot contribute directly to a Roth IRA. These limits also change yearly. However, there is a workaround called a "backdoor Roth" that allows higher earners to convert a Traditional IRA into a Roth, though this involves some tax planning and is not simple.

Unlike Traditional IRAs, Roth IRAs have no required minimum distributions. You can leave the money in the account as long as you want, and your heirs inherit it tax-free. You can also withdraw your contributions (not the growth) at any time without penalty, which makes a Roth useful as an emergency fund if you need it.

SEP IRA: For self-employed people and small business owners

A SEP IRA (Simplified Employee Pension) is designed for self-employed people, freelancers, and small business owners. It works like a Traditional IRA—contributions are tax-deductible, and you pay taxes on withdrawals in retirement. The major difference is the contribution limit: you can contribute up to 25% of your net self-employment income, up to a maximum that changes yearly. This is far more than a Traditional IRA allows.

SEP IRAs are simple to set up and maintain. You don't need a lot of paperwork or ongoing administration. If you have employees, you must contribute the same percentage of their salary that you contribute for yourself, which is why many solo business owners prefer a SIMPLE IRA instead.

Like a Traditional IRA, you must take required minimum distributions starting at age 73, and you can deduct contributions only if you don't exceed the income limits (though these are much higher for self-employed people).

SIMPLE IRA: For small businesses with employees

A SIMPLE IRA is designed for businesses with 100 or fewer employees. It lets employees contribute a portion of their salary, and the employer must either match those contributions or make a flat contribution for all employees. The annual contribution limit is lower than a SEP IRA but higher than a Traditional IRA.

SIMPLE IRAs require more paperwork than SEP IRAs because you're managing employee contributions and employer matches. However, they're still simpler than a 401(k). If you're a solo business owner with no employees, a SIMPLE IRA is not the right choice—use a SEP IRA or Solo 401(k) instead.

Like Traditional IRAs, SIMPLE IRA withdrawals are taxed as income in retirement, and required minimum distributions begin at age 73.

Contribution limits and how they change

The IRS sets annual contribution limits for IRAs, and these limits increase most years to account for inflation. For 2024, the limit for Traditional and Roth IRAs is $7,000 per year (or $8,000 if you're 50 or older). For SEP IRAs, you can contribute up to 25% of your net self-employment income, with a maximum that also changes yearly. SIMPLE IRA limits are different again and depend on employee deferrals.

These limits apply across all your IRAs of the same type. If you have both a Traditional IRA and a Roth IRA, your combined contributions cannot exceed the annual limit. However, you can have a Roth and a Traditional IRA at the same time, as long as your total contributions don't exceed the limit.

Check the IRS website or your financial institution for the current year's limits before you contribute. Contributing more than the limit triggers a penalty, and you'll have to withdraw the excess.

How to choose between Traditional and Roth

If you expect to be in a lower tax bracket in retirement than you are now, a Traditional IRA makes sense—you get a tax break today when your income is high, and you'll pay less tax in retirement when your income is lower. If you expect to be in the same bracket or a higher one, a Roth is usually better because you lock in today's tax rate and pay nothing in retirement.

Younger people often benefit from Roth IRAs because they have decades for the money to grow tax-free, and they're likely in a lower tax bracket now than they will be later. Older people closer to retirement might prefer Traditional IRAs if they want to reduce their taxable income right now.

You don't have to choose one forever. You can have both a Traditional and a Roth IRA at the same time, as long as your combined contributions don't exceed the annual limit. Some people split their contributions between both types to hedge their bets on future tax rates.

Frequently Asked Questions

Can I have more than one IRA?

Yes. You can have multiple Traditional IRAs, multiple Roth IRAs, or one of each. However, your total contributions across all Traditional and Roth IRAs combined cannot exceed the annual limit. If you have a SEP IRA or SIMPLE IRA, those are separate and have their own limits.

What happens if I withdraw money from my IRA before retirement?

With a Traditional IRA, you'll owe income tax on the withdrawal plus a 10% penalty if you're under 59½, with some exceptions (like first-time home purchase or medical expenses). With a Roth IRA, you can withdraw your contributions anytime without penalty, but withdrawals of growth before 59½ are taxed and penalized unless an exception applies.

Can I convert a Traditional IRA to a Roth?

Yes. You can convert all or part of a Traditional IRA to a Roth IRA at any time. You'll owe income tax on the amount converted in that year, but the money then grows tax-free in the Roth. This is called a Roth conversion and is a common strategy for higher earners.

Do I need to have self-employment income to open a SEP IRA?

Yes. You must have net self-employment income to contribute to a SEP IRA. If you have no business income, you can't use a SEP IRA. A Traditional or Roth IRA is the right choice if you have only W-2 wages from an employer.

What's the difference between a SIMPLE IRA and a 401(k)?

Both let employees defer salary and employers contribute. A SIMPLE IRA has lower contribution limits and less paperwork. A 401(k) allows higher contributions and more investment options but requires more administration and compliance. For a small business, a SIMPLE IRA is usually simpler and cheaper to run.