Like a 401(k), an IRA is a retirement savings account. You put money in it, and use that money to invest. But unlike a 401(k), an IRA does not have an employment requirement. IRA stands for Individual Retirement Account; anyone, even if he is not employed, can contribute to an IRA unless his income is too high. This works perfectly for freelancers such as my friends that are dancers and do not work for any particular company.
With an IRA, you are on your own for contribution and investment. You go to a brokerage company, say Fidelity, open an IRA with them, deposit your money in your IRA, and invest the money however you want.
Since an IRA is not sponsored by an employer, it gives you more investment flexibility than a 401k. Whatever investment option the brokerage company offers, you qualify for it. So with an IRA, you can buy individual stocks, individual bonds, options, etc. in addition to the diversified investing instruments that a 401k normally allows. You are no longer restricted to the severely limited set of mutual funds that your employer selected for their 401(k) plan.
And you are also not able to make a contribution via your paycheck directly into an IRA the way you would into a 401(k). If you want to contribute $2,000 into your Fidelity IRA this year, you have to bring the cash to Fidelity. Paycheck deduction is not an option.
A major source of contributions to IRA’s is rollovers from 401k. As long as you stay with an employer that sponsors a 401(k) plan, you can contribute to it, but when you leave, you will lose that ability. At this point, you can choose to keep the money in the plan, or roll it over to your IRA without losing any of the tax advantages of the 401(k). If you prefer the flexibility of the IRA over the 401(k), rollover is a great option. Some companies even allow in-service distribution, which means you can roll over your 401(k) money without terminating employment.
Basically an IRA is an individual brokerage account with tax advantages designed to encourage people to save and invest for retirement. If you want to have more flexibility in the choice of investment instruments, this is your ideal retirement savings account. I “discovered” the IRA when I was buying and selling stocks through my individual brokerage account, and immediately shifted my money from the brokerage account to my brand new IRA. It’s a no-brainer.
Next up are tax advantages of the 401(k) and the IRA.
-Richard (Hiep Tran)