There are several types of tax-advantaged Individual Retirement Arrangements (IRAs) that you can use to save for your future retirement. Some are for individuals and others can be used if you’re self-employed or have a small business. You must have some amount of taxable earned income—from a job, business, alimony, or from your spouse if you file taxes jointly—to be eligible to contribute to an IRA.
Many people get tripped up by thinking that an IRA is an investment. An IRA is simply an account that gives your investments certain advantages while they’re owned inside the account. In general, you can have more than one type of IRA, as long as you don’t exceed your allowable contribution limits for the year.
Keep reading and you’ll learn the different types of IRAs, how much you can contribute, and the kinds of investments you can make inside an IRA.
What is a Traditional IRA?
A regular or traditional IRA is the most basic type for individuals. If you have earned income and are younger than age 70½, you’re eligible to contribute to a traditional IRA. For 2011 and 2012 you can contribute an amount equal to your taxable income up to $5,000 or up to $6,000 if you’re age 50 or older.
The major advantage of a traditional IRA is that your contributions are tax-deductible, which means they reduce the amount of tax you have to pay. Here’s an example: If you contribute $4,000 to a traditional IRA and your average tax rate is 25%, you cut your tax bill by $1,000 ($4,000 x 0.25 = $1,000).
A traditional IRA doesn’t eliminate tax, but it allows you to defer it until you make withdrawals at some future date. You can begin taking distributions from a traditional IRA once you reach the official retirement age of 59½, and you must take minimum distributions after you turn 70½. In general, early withdrawals are subject to income tax plus a 10% penalty.
What is a Roth IRA?
A Roth IRA is the second type for individuals. It puts a twist on the rules because contributions are not tax deductible. In other words, you must pay tax on Roth contributions upfront, in the current year—but that’s where your taxation ends. When you retire and take distributions they’re completely tax free. You won’t owe a penny in tax for contributions or earnings that have accumulated over the years!
Additionally, there’s no requirement to take minimum distributions at age 70½, as there is with a traditional IRA. The funds in a Roth IRA can sit idle forever, which makes it a nice way to pass money to your heirs.
If you decide to take a withdrawal from a Roth IRA, you can tap your contributions at any time tax free. However, earnings in the account are subject to income tax plus an additional 10% penalty if you’re younger than age of 59½.
Just like with a traditional IRA, as long as you have earned income you can contribute up to $5,000 or up to $6,000 if you’re age 50 or older. However, when your income exceeds annual limits for your tax filing status, you become ineligible to contribute to a Roth IRA.
With either type of IRA, you’re in control of the account. You have the flexibility to choose from many different investments, such as bank CDs, money market funds, stocks, bonds, mutual funds, or exchange-traded funds (ETFs).
What is a Self-Directed IRA?
If you’re interested in putting your retirement money into more nontraditional investments, you might consider a self-directed IRA. It allows individuals to make extremely diversified and sophisticated investments, such as real estate, mortgages, businesses, and precious metals. You’re required to have a trustee or qualified custodian oversee your transactions and handle the disbursement or collection of funds.
A self-directed IRA has the same basic rules as a traditional IRA; however, it has additional restrictions, especially when it comes to buying real estate. You can’t use assets in a self-directed IRA for personal benefit until you reach age 59½, without putting the tax-deferred status of the account in jeopardy.
What is a SEP-IRA?
Now that we’ve covered 3 types of IRAs for individuals, let’s review 2 for businesses. A Simplified Employee Pension (SEP) is a retirement plan for a self-employed person or business owner with employees. It’s known as a SEP-IRA because employers can make pre-tax contributions to traditional IRAs set up for eligible employees, and for themselves.
A SEP-IRA is available to any size business—whether you’re a sole proprietor, a partnership, or a corporation—and is simple and inexpensive to set up and maintain. It’s a separate retirement plan that you can have in addition to a traditional or Roth IRA, or another workplace plan if you work a job in addition to having your own business.
A defining feature of a SEP-IRA is that it can only be funded by an employer and employees can never contribute their own money. However, an employee or owner-employee is always 100% vested (has full ownership) in the funds and can put it into most mainstream investments, like CDs, money market funds, stocks, bonds, mutual funds, and exchange-traded funds.
SEP-IRA contributions are at the discretion of the employer, but generally can’t exceed 25% of an employee’s annual W-2 compensation or 20% of an owner’s net self-employment income, up to $49,000 for 2011 and up to $50,000 for 2012.
When it comes to taking money out of a SEP-IRA, the rules are generally the same as a traditional IRA. You can withdraw funds as early as age 59½ and as late as 70½ without incurring a penalty. You can roll over funds from a SEP-IRA into a traditional IRA or another type of qualified retirement plan tax free.
What is a SIMPLE IRA?
A Savings Incentive Match Plan for Employees (SIMPLE) is a retirement plan for small businesses with fewer than 100 employees that can be set up as either a 401(k) or an IRA. It comes with fewer restrictions and paperwork than other types of workplace retirement plans, which makes it a great starter plan for small companies that want to minimize their administrative hassles.
With a SIMPLE IRA, employees elect to make contributions on a pre-tax basis and employers must contribute a set amount of matching funds. For 2011 and 2012, a worker can contribute 100% of their compensation up to $11,500 or $14,000 if you’re age 50 or older.
Employers must kick in SIMPLE IRA contributions on a dollar-for-dollar basis up to 3% of an employee’s compensation or make nonelective contributions of 2% of each employee’s compensation. Employees are always 100% vested in employer contributions.
You can withdraw funds as early as age 59½ and as late as 70½ without incurring a penalty. Taking an early withdrawal within 2 years of participating in a SIMPLE IRA comes with a steep 25% penalty—after that it’s reduced to 10%. After 2 years you can roll over funds from a SIMPLE IRA into a traditional IRA, Roth IRA, or another type of qualified retirement plan tax free.
Using one or a combination of tax-advantaged IRAs is a smart way to make your investment dollars go farther and to make sure you’ll have a healthy nest egg to spend during retirement.