A Look at the Many Different Types of IRAs
An individual retirement account (IRA) is an individual retirement account, right? Wrong. While many people are familiar with Traditional and Roth IRAs, there are in fact many other options to consider.
What makes each of the different varieties unique are the different advantages and disadvantages that they bring to the table. And, depending on your own situation, one type might fit your needs even better than your standard Traditional or Roth IRA does.
What is a Traditional IRA?
Let’s start at the time. The traditional IRA is the original and it remains the most popular type of individual retirement account in the U.S. This tax-advantaged account offers several features that benefit you now and in the future. A traditional IRA gives you an upfront tax break of up to $6,000. If you’re over the age of 50, you’ll get an additional $1,000 catch-up contribution.
Because contributions may be deductible, they lower your taxable income for the year. Traditional IRA earnings aren’t taxed, as long as the money remains in the account. Withdrawals are taxed at the rate that applies at the time.
These IRAs are best for people who are in a higher tax bracket now but expect to be in a lower bracket when it comes time for retirement. Traditional IRAs are also great for people who don’t have or aren’t eligible for an employer-sponsored retirement plan.
The Roth IRA Option
Remember we just said that Traditional IRAs are taxed when you withdraw from them in retirement and you get a tax break now. A Roth IRA is the opposite. Contributions are not deductible when you put money in, which means there are no upfront tax breaks, but your retirement withdrawals are tax-free.
Each year you can contribute up to $6,000 into the account, or $7,000 if you’re 50 or older. Your eligibility to contribute to a Roth IRA is income based. If you earn too much to contribute to this type of IRA, consider a backdoor Roth.
Compared to traditional IRAs, Roth withdrawal rules are much more lenient. These accounts allow for penalty- and tax-free withdrawals of your contributions at any time.
Roth IRAs are best if:
- You anticipate being in a higher tax bracket during your retirement years
- You may need to access the funds before you reach retirement age
A simplified employee pension (SEP) IRA is a type of traditional IRA. It’s set up and funded by an employer for employees, who receive tax benefits. SEP IRA earnings grow-tax free and retirement distributions are taxed. This type of IRA is beneficial in that:
- Annual contribution limits are much higher
- Employer must contribute equally to all employee accounts
- Sole proprietors can open their own SEP IRA
Unlike other IRAs, employees aren’t allowed to contribute via salary deferral. This type of IRA also doesn’t allow catch-up contributions, no matter your age.
SEP IRAs are best ideal for small business owners who don’t want the costs associated with a conventional retirement plan. They’re also beneficial for business owners looking to get a tax deduction on their contributions.
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is very similar to an employer-sponsored 401(k). This type of IRA is mostly for the self-employed and small companies. Unlike the SEP IRA, a SIMPLE IRA allows employees to contribute via salary deferral.
Depending on the plan, employers have to offer a 3% match or a fixed 2% contribution, based on the employee’s compensation. Unlike most employer-sponsored plans, SIMPLE IRAs allow participants to roll the money into a traditional account after participating for two years.
Tax-wise, SIMPLE IRAs are much like traditional IRAs. Contribution limits are higher than other retirement accounts. For 2021, the maximum contribution is $19,500.
This type of IRA is ideal for small companies with less than 100 employees. For the self-employed, a SEP IRA is usually the better option due to the higher contribution limits.
Self-directed IRAs have the same eligibility rules and contribution rules as traditional and Roth IRAs. The biggest difference is the type of funds that go into the account.
All of the other IRAs mentioned in this guide are limited to certain investment types, usually stocks, bonds, and mutual funds. However, with a self-directed IRA, you can own various other assets, including:
- Gold and other precious metals
- Real estate
- Privately held companies
But be aware that under IRS rules, self-directed IRA accounts cannot hold life insurance or collectibles. There are also many prohibited “self-dealing” transactions to be aware of.
Before you can set up a self-directed IRA, you must find a custodian (or trustee) that specializes in the kinds of investments that you want to hold in the account.
This type of IRA is best for experienced investors who are interested in alternative investments. Though self-directed IRAs offer many benefits, they come with all sorts of risks and regulations.
How to choose an IRA
Now that you know about the various types of IRAs, you may be wondering which type is best for you. There are several factors to consider.
First, think about your tax situation. Do you anticipate being in a higher bracket when retirement rolls around? If so, choose a traditional IRA. If the opposite is true, a Roth IRA is more ideal.
You’ll also want to consider the tax benefits. Are you looking for an account that you can use as a tax deduction? If so, a traditional or SIMPLE IRA fits the bill.
As with any type of investment account, it’s important to shop around for a custodian. Of course, if you’re participating in an employer-provided account, you don’t have any say in who holds the account.
But for those opening an IRA on their own, don’t settle for the first custodian you find. Compare fees and the types of IRAs that are offered.
In saving for retirement, make sure that you choose an IRA that best meets your tax and contribution needs.