Breaking Down The Different Kinds Of IRAs
This content is for informational purposes only and not intended to be investing advice.
One of the ways you can fund your retirement plan is by using the Individual Retirement Account (IRA). You can establish an IRA as long as you earn income. Understanding what IRAs are and the different types will help you make the best investment decision to reach your retirement savings goals.
What are IRAs?
An Individual Retirement Account (IRA) is a saving account with tax advantages that you can open to save and earn interest in the long term. The IRA encourages individuals to save for retirement. You can open an IRA through an online brokerage or an investment company as long as you have earned income.
You can’t withdraw money from your IRA before you reach 59 and half years. If you withdraw before that time, you’ll incur a penalty of 10% of the withdrawal amount. Once you open an IRA, you can choose to invest in a wide variety of products, such as bonds, mutual funds, stocks, and exchange-traded funds.
Types of IRAs
There are different kinds of IRA and each type has its own rules regarding taxation, eligibility, and withdrawals. Here are the 7 different types of IRAs.
1. Traditional IRAs
Traditional IRAs are the most popular retirement savings account. The contributions you make to traditional IRAs are tax-deductible. When you withdraw your money in retirement, you’ll be taxed on your ordinary income tax.
Therefore, your money grows on a tax-deferred basis. Your annual individual contributions cannot exceed $6,000 for 2021 and 2022. However, for anyone who is above 50 years, the contribution can go up to $7,000 per year. Here are some features of the traditional IRA.
- The investment earnings are not taxable as long as the money remains in the account.
- There is an upfront tax break of $6,000 for 2021 and 2022 and an extra $1,000 if you are 50 years and above.
- Withdrawals are taxed at the current tax rate.
Best for: If you are in a higher tax bracket than you’ll be in your retirement, then a traditional IRA is a suitable option.
2. Roth IRAs
You make the Roth IRA contributions using your after-tax dollars but do not pay taxes on your investment gains. Upon retirement, you can make withdrawals without incurring income taxes. There are no minimum distributions on the Roth IRAs. As long as you have earned income, you can continue to contribute to your account even when you are old. Here are some features of the Roth IRA.
- It allows for penalty-free withdrawals at any time.
- The maximum annual contribution is $6,000 and $7,000 if you are above 50 years.
- Contributions are not deductible
Best for: If you anticipate that you’ll be in a higher tax bracket in your retirement, then the Roth IRA is the best investment option.
3. SEP IRAs
If you are a freelancer, independent contractor, or small business owner, then a SEP IRA is an ideal option. SEP stands for Simplified Employee Pension. The SEP-IRA contributions for 2022 are limited to 25% of compensation or $61,000, whichever is smaller. Here are the features of SEP IRA.
- There is no catch-up for workers who are 50 years and above.
- Contributions vary from year to year depending on the cash flow.
- Employers contribute equally to the employee accounts.
- The annual contributions are higher compared to other tax-favored accounts.
Best for: These are most suitable for small-business owners who want to avoid the operating costs of the retirement plan.
4. Simple IRAs
The Simple IRA (Savings Incentive Match Plan for Employees) is suitable for self-employed and small business individuals. It has the same tax rules for withdrawals as the traditional IRA. With Simple IRAs, you can make contributions to your account, and your employer is also required to make the contributions. The contributions are tax-deductible, which pushes you to a lower tax bracket. The contribution limit for 2022 is $14,000 and for those above 50 years, it is $3,000. Here are some features of the Simple IRA.
- It allows for catch-up contributions. If you are 50 years and above, you can save an extra $3,000.
- It has lower contribution limits than 401(k). The contribution is $14,000 in 2022.
- Early withdrawals within the first two years attract a 25% penalty.
Best for: If you have a smaller company with less than 100 employees, then you should open a Simple IRA.
5. Nondeductible IRA
If your income is above the IRA income limits, you will be unable to deduct the traditional IRA contribution. However, you can still make contributions to an IRA.
Best for: If you don’t qualify for the deductible IRA, then you should opt for the Nondeductible IRA.
6. Spousal IRA
According to the IRS rules, you need an income to be eligible for IRA contributions. If you are married and one of you is not working or has a low income, you can still contribute to your separate IRAs. Here are the features of the spousal IRA.
- The total amount contributed has to be less than your joint taxable income.
- Contributions limits are the same for Roth and traditional IRAs. The working spouse contributes an amount the same as their IRA while the non-working spouse contributes $6,000 or $7,000 for those older than 50 years.
- Couples have to file a joint tax return to be eligible
Best for: Non-working and low-income individuals who are married to someone with an earned income.
7. Self-directed IRA
The self-directed IRA follows the sale contribution rules like the Roth and traditional IRAs. The only difference is what goes into the account. With a self-directed IRA, you can own assets like gold and even real estate.
Best for: The self-directed IRA is suitable for experienced investors who want access to real estate and nontraditional businesses.