Types of IRAs
One way to fund a retirement is through an Individual Retirement Account (IRA). An IRA is a tax-sheltered retirement account set up at a bank, investment firm, or insurance company. IRAs can be made up of mutual funds, stocks, bonds, bank deposit accounts, and most other types of investments.
All individuals who have earnings from salary or wage income are eligible to establish an IRA. In addition, unemployed spouses of wage earners are also eligible to open an IRA. The Internal Revenue Service establishes guidelines on a yearly basis regarding the amounts that can be contributed to an IRA. These guidelines take into account your income, income tax filing status, and age. In 2021, the contribution limit is $6,000, or $7,000 if you’re age 50 or older.
There are three types of IRAs. Understanding the difference will help you determine which is the best option for your retirement savings goals.
Traditional or deductible IRA
An advantage of the traditional IRA is that contributions can be taken as tax deductions in the tax year they are made. These deductions reduce your gross income, thus reducing your tax burden. Both contributions and earnings are tax-deferred until the funds are withdrawn.
It's important to note, however, that if your income is too high you may not be eligible for these deductions. For example, if your 2022 modified gross adjusted income exceeds $78,000 as a single/head of household tax payer and you have a retirement account at work, your contributions to a traditional IRA won't be eligible for tax deductions. In the case where income limits prevent you from taking advantage of a deductible IRA you may want to use a nondeductible IRA instead.
Who should use a traditional IRA?
This type of account benefits individuals whose tax rate will decrease between the time of deposit and when the money is withdrawn. In other words, if you believe you'll be in a lower tax bracket once you retire (and most of us will), this may be your best bet.
Workers who are not eligible to contribute to an employer-sponsored retirement plan can make contributions to a traditional IRA, regardless of income.
The major difference between a traditional and nondeductible IRA is the ability to deduct yearly contributions on your income taxes. Contributions made to a nondeductible IRA are taxed as ordinary income in the year they are deposited and cannot be deducted from gross income. Thus, at the time you withdraw funds from a nondeductible IRA, you only pay income taxes on the earnings, as your yearly contributions have already been taxed.
The major advantage of this type of IRA is the tax-deferred growth of contributions and earnings. Nondeductible IRAs provide an investment option for individuals who don't meet the eligibility criteria for a traditional IRA or for those whose adjusted gross income exceeds the limits for the Roth IRA.
You may begin withdrawing money from traditional and nondeductible IRAs in the year in which you turn 59. Withdrawals before the age of 59 are permitted but are subject to a 10% penalty. In addition, early withdrawals are included in your gross income for tax purposes in the year the money is withdrawn. You must begin withdrawing from a traditional or nondeductible IRA during the year in which you turn 70 so that funds will be depleted based on life expectancy for your age.
Who should use a nondeductible IRA?
The two major reasons to use a nondeductible IRA is that you aren't eligible for a deductible IRA (most often due to income exceeding the maximum limit) or because you prefer to collect your tax savings at the time of retirement, once you begin withdrawing funds.
This is the one you have probably heard the most about in recent years. The Roth IRA was established in 1998 and is very different from the traditional and nondeductible IRAs.
Contributions to a Roth IRA are taxed as income in the year they are deposited, similar to the nondeductible IRA. Thus, contributions cannot be taken as tax deductions. However, at the time of withdrawal, the earnings on those contributions are not taxable. After age 59, all or part of a Roth IRA may be withdrawn income tax-free and without penalty.
Under certain circumstances, the IRS allows penalty-free and tax-free early withdrawals on Roth IRAs. Two criteria must be met: the withdrawal must be used for a qualified purpose and cannot be made until five years after the account was opened. Examples of qualified purposes include the purchase of a first home and the payment of higher education expenses.
As with the other IRAs, nonqualified withdrawals are subject to a 10 percent penalty. Unlike the other two types of IRAs, there is no requirement that dictates when funds must be withdrawn from a Roth IRA. For example, the entire account may be left to your heirs without penalty.
Who should use a Roth IRA?
The tax-free withdrawals would best serve someone who ends up in a higher tax bracket once they've retired. Roth IRAs are also much easier to dip into prior to retirement. So while it's rarely ever a good idea to dip into your retirement savings ahead of retiring, if you think you may need to fund a home purchase or a secondary education, the Roth IRA gives you more flexibility.
Less common types of IRAs
While deductible, nondeductible, and Roth IRAs are the dominant options, there are a few important variants to be aware of.
Typically, you need an income before you can contribute to an IRA. However, if you're married and your partner has an income, but you don't (or your income is very low), you can still open your own traditional or Roth IRA. The account needs to be opened in the non-earning spouse's name, but can be funded with money earned by the other spouse.
A simplified employee pension (SEP) is a variation on the traditional IRA that's used primarily by small business owners who can't handle the cost of operating a traditional retirement plan for their employees. Employers receive tax benefits, including tax deductions on contributions made for their employees. You can even open a SEP IRA as a sole proprietor (meaning you're the boss and the only employee), but be sure to follow all of the requirements or else risk running afoul of the IRS.
A savings incentive match plan for employees (SIMPLE) is another option for small companies and the self-employed. Unlike SEP IRAs, however, employees have the option of contributing through a salary deferral. Participants also have the option to roll their SIMPLE IRA into a traditional IRA after two years on the plan.
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