Individual Retirement Accounts: Understanding The Types

Individual Retirement Accounts (IRAs) are pretty sweet for saving up for retirement and getting some tax perks. They're awesome for self-employed folks, people without a work retirement plan, or anyone maxing out their work plan already. Basically, you put money in an IRA, pick your investments, and depending on the type, you either don't pay taxes now or later. Let's find out about the various types of IRA in this article.

SIMPLE IRAs: Allows Contributions From Employers and Employees

SIMPLE IRAs let both employers and employees chip in. They're great for small businesses that don't have a retirement plan to offer but still want to help employees save. Small business owners can get tax benefits and give their team a reason to stick around. Employees can defer a portion of their salary, up to $15,500 for 2023, with a catch-up contribution of $3,500 for those 50 and older. Employers must either match employee contributions up to 3% of their compensation or make a non-elective contribution of 2% of each eligible employees compensation.

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SEP IRAs: Best for Self-Employed People

SEP IRAs are perfect for self-employed people. You can put in up to 25% of your business profit or $69,000 for 2024, whichever is less. Contributions are tax-deferred until you pull the money out in retirement. Some folks mix a Roth IRA with a SEP IRA to handle taxes now and save more. This combo is popular with sole proprietors or small businesses with just one other employee, plus freelancers and consultants. Only employers contribute to SEP IRAs, and they can contribute up to 25% of an employee's compensation or $66,000 (for 2023), whichever is less. Contributions are flexible and can vary each year. Contributions are tax-deductible for the employer, and employees do not pay taxes on contributions until they withdraw funds. Withdrawals from a SEP IRA are taxed as ordinary income, and early withdrawals before age 59 may incur a 10% penalty.

Rollover IRAs: Useful for Job Change or Retirement

A rollover IRA is when you move your old job's retirement plan into an IRA when you change jobs or retire. It keeps your moneys tax-deferred status and can be moved to a new employers plan. There are no contribution limits for rollovers, but regular contribution limits apply for new contributions ($6,500 for 2023, plus a $1,000 catch-up for those 50 and older). Transfers are not taxed, provided the rollover is completed within 60 days, and the funds continue to grow tax-deferred. Withdrawals from a Rollover IRA follow the rules of Traditional or Roth IRAs, depending on the type of IRA the funds are rolled into.

Roth Conversion IRAs: Tax-Free Earnings & Contributions

A Roth conversion IRA is about switching a traditional IRA to a Roth IRA. You pay taxes now so you don't have to worry about them later. You report the IRA funds as income and pay taxes, which might bump you into a higher tax bracket that year. Anyone can convert funds to a Roth IRA, but the amount converted is subject to income tax. Regular Roth IRA contribution limits apply after conversion. The significant advantage of a Roth Conversion IRA is that future withdrawals of contributions and earnings are tax-free, provided certain conditions are met. Contributions can be withdrawn anytime tax-free, while earnings can be withdrawn tax-free after age 59 and if the account has been open for at least five years.

Roth IRAs: Upfront Tax Payment

Roth IRAs are like traditional IRAs, but you pay taxes upfront. Some folks prefer this to avoid paying income tax when they withdraw later in life. The contribution phase-out begins at $138,000 for single filers and $218,000 for joint filers. Individuals can contribute up to $6,500 for 2023, with a $1,000 catch-up contribution for those 50 and older. Contributions to a Roth IRA are not tax-deductible, but the earnings grow tax-free, and qualified withdrawals are also tax-free. Contributions can be withdrawn anytime without taxes or penalties, while earnings can be withdrawn tax-free if the account is at least five years old and the account holder is at least 59, disabled, or using the funds for a first-time home purchase (up to $10,000).

Traditional IRAs: Perfect for a Large Bracket of People

You can get a traditional IRA if you have taxable income and aren't turning 70 1/2 this year. The max you can put in is $7,000 a year, or $8,000 if you're 50 or older. You don't pay taxes until you withdraw, and you can deduct contributions from your income to lower your tax bill. Just remember, if you take money out before 59 1/2, you'll get hit with regular income tax and a 10% penalty, unless there's an exception. Contributions to a Traditional IRA may be tax-deductible, depending on income and whether the individual or their spouse is covered by a workplace retirement plan. The earnings in a Traditional IRA grow tax-deferred, and withdrawals are taxed as ordinary income. Early withdrawals before age 59 may incur a 10% penalty.

Nondeductible IRA: Great for Spouses

If you or your spouse has a retirement plan at work and you make too much money, you might not be able to deduct traditional IRA contributions. But you can still put money in. Contributions are after-tax, meaning no deduction, but your earnings grow tax-deferred. When you retire, you pay taxes on the earnings, but not on the original contributions since they were already taxed. The contribution limits are the same as those for Traditional and Roth IRAs, but contributions are made with after-tax dollars. Although the contributions are not tax-deductible, the earnings grow tax-deferred. Withdrawals of contributions from a Nondeductible IRA are not taxed, but earnings are taxed as ordinary income. Early withdrawals of earnings may incur a 10% penalty.

Opening and Moving IRAs

You can set up an IRA at various financial institutions like banks, credit unions, and brokerage firms. When you're comparing options, keep an eye on monthly fees, commissions, and minimum opening requirements since these vary by company. For instance, Farm Bureau Bank offers several IRA options with no monthly fees.  Got an old retirement account from a previous job? If you already have an IRA or 401(k) but want to switch it to another company, there are ways to do this without triggering taxes and penalties.

Restrictions and Eligibility Requirements

To open an IRA, you or your spouse need to have earned income from a job. The IRS has some extra rules if you want the tax benefits. If you're part of an employer-based retirement plan like a 401(k), there are limits on tax deductions for Traditional IRAs based on your income and filing status. Roth IRAs also have contribution limits tied to your income and filing status. Check the latest IRS guidelines to ensure you're eligible and can maximize the benefits of an IRA.

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Choosing the Right IRA

It's important to consider your current tax situation versus your future taxes in retirement, but predicting future taxes can be tough, especially if you're younger. Think about other income sources you'll have in retirement and how to diversify your tax exposure. For example, if you have a 401(k) for retirement income, you'll pay taxes on those distributions. Social Security benefits are also taxable for most people. Opting for a Roth IRA and paying taxes now could provide tax-free retirement income. Always consult with a tax professional when making financial decisions that affect your tax status.

Conclusion

Whether you're starting your retirement savings, looking for tax deductions, or planning to diversify your retirement income and tax exposure, an IRA can be a valuable tool. The flexibility in how your contributions are invested, along with upfront or future tax breaks, lets you take control of your financial future. This guide will help you to choose the best IRA for you.

Frequently Asked Questions

What is the differentiating factor between a 401(k) and an IRA?

\A 401(k) is available only through an employer, while anyone with work income can open a traditional or Roth IRA. Some 401(k)s also offer matching employer contributions. Understanding the key features of both can help you decide the best path for your retirement savings.

How many IRAs can one individual hold?

The IRS doesn't limit the number of IRAs you can own, but there is a cap on the total amount you can contribute to all of them. You might want multiple IRAs for investment and tax diversification, inheritance planning, and withdrawal flexibility. Consider your short- and long-term needs to decide if multiple IRAs are right for you.

Is there a correct age to open an IRA account?

There's no perfect age to open an IRA it depends on your life stage. You can open one at any age as long as you have work income to fund it. Whether you're just starting out, in the middle of your career, or nearing retirement, an IRA can be a good fit.

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