IRA

7 Types of IRAs - Which One is Best for You?

Most people are familiar with at least two types of IRAs (Individual Retirement Accounts), but not many know there are actually seven (7) types of IRA accounts. Choosing the best one for you is based on several factors such as your income, employment status, and what your current employer offers to name a few. A trusted financial planner or tax advisor can help guide you. 

Essentially, an IRA is a tax-saving, money-growing account intended for use in retirement. There are many rules regarding contribution limits, when funds may be added and withdrawn, and how the funds are taxed. Let’s review the 7 types of IRAs that may benefit you and your financial situation. 

There Are 7 Types of IRAs

  1. Traditional IRA

  2. Roth IRA

  3. SEP IRA

  4. Nondeductible IRA

  5. Spousal IRA

  6. SIMPLE IRA

  7. Self-directed IRA

TRADITIONAL IRA

This is the most popular and best known of the individual retirement savings accounts. Traditional IRAs were first available to citizens in 1975 with limits based on incoming, tax filing status, and availability of other retirement plans. All contributions to a traditional IRA, including interest, dividends, and capital gains are not subject to taxes while they remain in the IRA. Financial institutions generally offer better savings rates on IRAs than savings accounts and certificates of deposit.  

When you contribute pre-tax income into the account it may help lower your tax liability for the year, based on your income bracket. Account owners pay taxes when withdrawals are made at the tax rate of your income at that time. This could be an issue in retirement if you are in a much higher income tax bracket than you are now since taxes could significantly reduce your gains. A traditional IRA is a good option for retirees who expect to be in a lower income tax bracket. 

The funds in your IRA are protected against creditors should you ever face financial difficulties. And they can be transferred to a Roth IRA once during the original owner’s lifetime.

  • In 2020 and 2021, individuals can contribute $6000 to their IRA. 
  • If you are over 50, individuals can contribute $7000 for 2020 and 2021.

Transfers and Rollovers: A transfer occurs when the financial institution receiving the funds requests the money be transferred to them. A transfer is allowed between traditional IRAs or from an employer plan and it is not reported to the IRS. 

Rollovers, sometimes called a 60-day rollovers, can move IRA funds from one institution to another. A check is made out to the account holder and they have 60 days to deposit it to an appropriate IRA before triggering tax liabilities. Owners may only use a rollover once every 12 months with the same funds and the transaction is reported to the IRS. 

Possible disadvantages of a traditional IRA: There are income limits if you participate in your employer’s retirement plan. If your income is below that limit, a Roth IRA may be more beneficial since those contributions are taxed first. A traditional IRA should not be considered an emergency fund prior to retirement age.

If money is withdrawn before age 59½, the IRS (Internal Revenue Service) adds a 10% tax penalty on top of the owner’s income tax rate at the time the withdrawal or distribution is done. There are a few exceptions to this penalty, such as first home purchase (up to $10,000), college education, and disability to name a few. 

Traditional IRA owners must take a required minimum distribution (RMD) beginning at age 72 (or 70½ if you reach 70½ before January 1, 2020). All RMD withdrawals will be included in your taxable income. Be aware that IRA owners face a 50% penalty on the dollar amount of the RMD for that year if they fail to take the distribution. 

Consider a traditional IRA if you are in a higher income tax bracket now and expect to be in a lower income tax bracket in retirement. Consult with your tax advisor to determine if the tax benefits are best for you.

ROTH IRA 

The Roth IRA, originally called an “IRA Plus”, was established in 1997 by Congress, more than 20 years after the traditional IRA. The IRS has income limits for contributing to a Roth IRA, just as the traditional IRA does, so discuss this with your financial planner. You may make after-tax contributions to a Roth IRA even if you participate in a qualified retirement plan such as a 401(k).

The Roth IRA is different from a traditional IRA since you make contributions after income taxes have been paid. This means funds are tax-free and penalty-free when they are withdrawn after five years provided the account owner is at least age 59 ½. This IRA can often be used as supplemental income in retirement.

For 2020 and 2021, the contribution limits were raised and are the same as the traditional IRA above.

You are not required to take RMDs (required minimum distributions) from your Roth IRA, unlike a traditional IRA which requires them to begin at age 72. If the funds are not needed, they can be left in the Roth IRA and passed on to heirs. Be aware that beneficiaries will be subject to minimum distribution rules, so discuss these options with your financial planner. 

Possible disadvantages of a Roth IRA: If you are in a higher income tax bracket, there are income limits to being able to contribute to a Roth IRA. Contributions are taxed at your current income tax rate, so if you are in this higher bracket, a traditional IRA may be more suitable. Be aware that funds cannot be used as collateral for a loan or as a cash management tool for investment purposes. 

IRAs are subject to rule changes by Congress and the tax-free withdrawals could be eliminated. A qualified financial advisor, such as a CERTIFIED FINANCIAL PLANNER™ professional, can assist you in making decisions and keep you advised of possible changes to the rules. 

Consider a Roth IRA if you expect to be in a higher tax bracket in retirement than you are now. Your contributions will be added to your retirement savings account at a lower tax rate and can be withdrawn tax-free after age 59 ½. 

SEP-IRA

A Simplified Employee Pension IRA, or SEP-IRA, is a business retirement plan set up by employers for the benefit of employees. The tax benefit for the employer is that earnings grow tax-free and are deductible, lowering tax liability in the contribution year.  

Contributions must be made to the IRA by the filing deadline for the employer’s tax return. Funds are taxed at the recipient’s tax rate when qualified withdrawals are made after age 59 ½. 

The employer may contribute up to 25% of the employee’s wages, or $57,000 for 2020 (whichever is less) to the employee’s SEP-IRA account and must contribute an equal percentage amount to all employee accounts. The percentage amount can change each year as long as it is the same for each employee. 

If you are a solo entrepreneur, you may set up a SEP-IRA to save for your own retirement. Contribution limits are much higher, with a compensation cap of $285,000 in 2020 and $290,000 in 2021 at 25%. There are catch-up contributions permitted after age 50. 

SEP IRAs require minimum distributions beginning at age 72, and withdrawals before age 59½ are taxed as income and subject to a 10% penalty by the IRS.

Possible disadvantages of a SEP-IRA: there are specific IRS rules to follow, so it is important to implement them properly either on your own or with an experienced financial planner. Contributions must always be cash and not property or other goods. 

Consider a SEP-IRA if you are a small business owner. The SEP-IRA can help avoid the costs of a conventional retirement plan. 

NONDEDUCTIBLE IRA

A nondeductible IRA helps if you have a retirement plan, such as a 401(k), at your place of employment and your income exceeds the IRA income limits, since contributions to a traditional IRA may not be tax-deductible. You can still contribute to your IRA using after-tax dollars and you still get tax-deferred growth on earnings within the account.

When funds are withdrawn in retirement, taxes are only due on any earnings growth you withdraw, but not on the principal contributions.

Consider a nondeductible IRA if you don’t qualify to contribute to a Roth IRA or a traditional IRA. 

SPOUSAL IRA

A spousal IRA is permitted, even if one spouse does not have earned income. The IRS recognizes that married taxpayers may have one spouse who does not work, or earns a very low income, and allows both parties to contribute to separate IRAs (either Roth or traditional). Couples must file a joint tax return to be eligible to contribute to a spousal IRA.

Contribution limits are the same as those for a traditional or Roth IRA, with catch-up amounts for individuals age 50 or older. The total contribution amount must be the lesser of the joint taxable income or double the annual IRA contribution limit.

Consider a spousal IRA if one spouse earns a very low, or no, income in order to contribute to retirement savings. 

SIMPLE IRA 

The SIMPLE IRA (Savings Incentive Match Plan for Employees) was created for small companies and self-employed individuals to operate like an employer-sponsored 401(k). It differs from the SEP-IRA by allowing employees to contribute to the IRA through a salary deferral. The SIMPLE IRA tax rules are similar to a traditional IRA. 

For 2020 and 2021, contribution limits are at $13,500, lower than a 401(k). The business owner may be required to contribute up to a 3% matching contribution, or a fixed contribution of 2%, for each employee. Catch-up contributions are allowed at an additional $3,000 if you are age 50 or older.

After two years of participation in the SIMPLE IRA, all participants are permitted to transfer their funds to a traditional IRA if desired. 

A possible disadvantage of a SIMPLE IRA: There may be a 25% penalty in addition to regular tax liabilities if funds are withdrawn within the first two years of contributing to the account.

Consider a SIMPLE IRA if you own a company with fewer than 100 employees or are self-employed.

SELF-DIRECTED IRA 

When the Employee Retirement Security Act, or ERISA, was created in 1974, both the traditional IRA and self-directed IRAs were available to citizens the following year. In 1975, the maximum contribution to an IRA was $1,500, slowly increasing to $6,000 in 2020. 

The primary difference between self-directed and other IRAs is the types of assets you own in the account. Self-directed IRAs offer investment options such as real estate or a privately held company. This account requires a trustee or custodian who specializes in such investments. The possibility of higher returns attracts some people, but there are also greater risks involved than with a traditional IRA. 

Possible disadvantages of a self-directed IRA: If the investment fails, you will lose your IRA money. If you fail to follow the IRS rules, you may lose your tax benefits and owe penalties and interest. Be sure to do your research and hire someone you can trust to manage this type of account. 

Consider a self-directed IRA if you understand investments in certain segments particularly well and are able to take advantage of higher yields. 

Which One is Best for You? 

Every financial situation is different so let a CERTIFIED FINANCIAL PLANNER™ professional, or another financial advisor, help you decide the best options based on your tax bracket. If your tax brackets will be going up in retirement, for example, then a Roth IRA makes sense. If your tax bracket is expected to go down in retirement, then a traditional IRA may work better. 

The deadline to contribute funds to your IRA is midnight, usually on April 15, for the previous year. That date may change if the tax filing deadline date changes.  Consult a qualified advisor to make your contributions count for the tax bracket you are currently in and the one you expect to be in when you retire. 

We’re Here To Help You 

Elijah Heath, a CERTIFIED FINANCIAL PLANNER™ professional, is a *fiduciary with an ethical obligation to provide information, products, and services in your best interest, not what earns him the best fee or commission. Heath Wealth Management wants to be your advisor for life so you, your children, and your grandchildren all benefit from the relationship.

Call us to learn more, ask questions about your specific circumstances, and determine if we are the right fit for you. Our phone number is 813-556-7171. We can also be reached by email at Elijah.Heath@LPL.com.

*Fiduciary services are for advisory relationships only.