In the years to come, you will finally retire from your job or business, which will leave you with lots of free time to spend as well as several post-retirement goals to work on. Other savings accounts may not be enough to cater for all your retirement needs. This is where an IRA can be beneficial.
With an IRA, you not only save for your retirement but also enjoy tax advantages, depending on your chosen plan. While you mull over how you can benefit from an IRA, let’s dig deeper into understanding the different types of IRAs.
Key IRA Highlights
- Withdrawing money from your IRA before the age of 59 1/2 will attract an early withdrawal penalty of 10%.
- Contributions of traditional IRA are tax-deductible up to IRS limits, and until you withdraw the funds, you don’t owe income taxes.
- Roth contributions are not taxed. In addition to tax-free investment growth, you also get tax-free money withdrawals once you retire.
- Both Roth and traditional IRAs allow you to save up to $6,000 per year, or $7,000 if you are 50 or older.
- Other types of IRAs — SIMPLE, SEP, Spousal, Backdoor ROTH, Inherited, and Self-directed IRAs — also have myriad benefits under different circumstances.
Also known as an Individual Retirement Account, an IRA gives you a tax advantage when you save money for retirement. You can get an account at a brokerage firm, bank, insurance fund, mutual fund company, or other financial institution. Depending on the financial institution you open the IRA account with, you either get tax-deferred or a tax-free growth when you save for retirement.
The more you contribute to your IRA, the more you can get out of the savings, so aim to contribute the maximum amount.
Contrary to popular belief, an IRA is not an investment but an account that acts as a holder or a shell, which gives you more investment options compared to your employer-sponsored savings plan. How to invest with the money in your IRA account is purely your choice; you have various investment choices ranging from mutual funds to government bonds to stock trading, among others.
Keep in mind, you have to monitor your investments, make adjustments where necessary as you get closer to your retirement. But before investing, seek investment training or advice from experts to maximize the return potential of your investment.
Here, you get tax-deferred growth on your IRA funds, which means you pay no income tax on your capital gains, dividends, or interest unless you take a withdrawal.
Anyone can open a traditional IRA, regardless of income. However, if you or your spouse is liable to a retirement plan at work, then your income will determine the amount of your contribution that you can deduct from your taxes. With that in mind, in case you or your spouse is under a retirement plan at work, it’s necessary to check out in order to confirm your deduction limits.
This plan may be the right choice for you if getting an upfront tax break now is your priority. However, you can delay the tax bill until later on to potentially pay a lower tax rate in retirement.
Remember you will need to meet some specific requirements or be of age 59 1/2 to be able to take money out of a traditional IRA without incurring withdrawal penalties.
Are you comfortable with waiting to get your tax break? Well, then the Roth IRA is your option. Here, contributions aren’t subject to tax deductions, and you watch your money grow tax-free. That is, any money you withdraw in retirement is tax-free. Similarly, you don’t owe any tax on the investment gains in your account. But keep in mind that while you’re still saving, you are not allowed to deduct Roth contributions from your taxable income.
Another advantage of a Roth IRA is that there is no penalty at any given time you choose to take out the money you contributed. Note that there are rules that guide the early withdrawals of your investment earnings.
Backdoor Roth IRA
If you are a higher earner, the set income limits may prevent you from contributing to a Roth IRA. And that’s where the Backdoor Roth IRA option can be an option for you. Here, you open a traditional IRA and convert it to a Roth. But there is a catch to it — all your traditional IRA accounts must entirely consist of nondeductible contributions; otherwise, the money you convert to a Roth IRA will be taxable.
The non-working spouse owns the spousal IRA. You can contribute up to a maximum of $6,000 per year if you’re below 50; if you’re 50 or older, you can contribute up to $7,000 per year. Still, the total amount you contribute to each of your IRAs can’t go beyond the income of the working spouse.
Simplified Employee Pension (SEP) IRA
SEP is ideal for self-employed people and small business owners. Similar to a traditional IRA, your contributions are taxable, besides offering you a tax-deferred savings growth. When you retire, your withdrawals get taxed at regular income tax rates.
It’s worth noting that you will contribute to accounts of your employees at the same rate you contribute to your account as required by the IRS. For instance, if you are saving 15% of your compensation, your employees get the same percentage of their salary added to their accounts. In general, employees are barred from contributing to a SEP.
The motivating factor here is that a business account owner can contribute a maximum of $56,000 in 2019 (far better than the traditional IRA’s maximum of $6,000). On the contrary, your contribution can’t go beyond 25% of your total compensation.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
If you have a small company with no more than 100 employees, then a SIMPLE IRA can be your best choice. Unlike in a 401(k), employees find it easier to set up a SIMPLE IRA because like its coincidental acronym, it’s also simple for you and your employees to understand.
The IRS has specific rules guiding employees’ contributions to the plan. Employees are allowed to contribute their own money up to $13,000 a year, which makes it better than the SEP IRA plan. Employees who are 50 or older get an additional $3,000 catch-up contribution. Your contribution reduces your taxable income for the year, as the money grows tax-deferred. But, you’ll be charged income tax for withdrawals in retirement.
Beneficiary (Inherited) IRA
In this plan, you open an account to inherit an IRA account whose owner died. Anyone can be a beneficiary: friend, spouse, relative, or an unrelated party. The assets in the deceased person’s IRA get transferred to a new inherited IRA account under the beneficiary’s name.
You have to follow the specific inherited IRA rules, which vary depending on how you relate to the deceased. For a non-spouse, you may not treat an inherited IRA as your own. In addition, the taxes are only due when you receive the distributions.
Self-Directed IRA (SDIRA)
These accounts have similar income and eligibility rules as Roth and Traditional IRAs.
Whereas other IRAs are limited in terms of the types of investments you can hold in the account, an SDIRA gives you a broader array of assets to invest in. You have the freedom to hold private placements, commodities, precious metals, tax lien certificates, real estate, among others. For that matter, it requires greater due diligence by the account holder. If you decide to trade using this account, here are some tips to help you succeed.
The stumbling block of an SDIRA is finding a custodian willing to let you make the alternative investments as most household brokers are unwilling.
Get Started Investing in an IRA
Since you now understand different IRA plans available, it’s time to choose the best one that suits you and start investing. On matters of investing, there’s no need for guesswork when there are proven ways that will almost always guarantee you success. Use this new knowledge to choose one of the IRA plans to get you started right away.