What Are the 3 Types of IRAs?
Individual retirement accounts (IRAs) provide tax advantages that help savers build wealth over time, yet not all IRAs are created equal – each type has different rules and contribution limits.
Traditional IRAs allow for tax-deductible contributions from pretax compensation sources such as wages, salaries, commissions, tips and bonuses. Withdrawals will be taxed according to your current income rate.
Traditional IRA
A traditional IRA allows you to deduct contributions from your taxes, while investing them tax-free until retirement when the money must then be withdrawn at your normal income tax rate. Any withdrawals would then be taxed at this same rate.
Those withdrawing funds prior to age 59 1/2 will incur an early withdrawal penalty of 10 percent, in addition to paying taxes and penalties on them. There may be exceptions such as covering financial hardship or higher education costs.
Some business owners may choose a Simplified Employee Pension Plan (SIMPLE) IRA, similar to a traditional IRA but tailored for small businesses and the self-employed. Contributions are made by employers based on cash flow while individuals can make salary deferral or catch-up contributions; many of the same rules apply as with traditional or Roth IRAs; additionally a SEP IRA may hold nontraditional investments such as hedge funds.
Roth IRA
Roth IRAs provide tax-free withdrawals upon retirement if you adhere to their rules, making them an attractive choice for individuals unable to contribute to a 401(k) plan or other employer sponsored retirement plan.
Traditional IRAs can also be beneficial to those expecting to fall into higher tax brackets during retirement; withdrawals from traditional IRAs will only ever be taxed at your current income tax rate, regardless of when or how they’re withdrawn from.
No matter which IRA type you select, you have access to an extensive array of investments such as stocks, mutual funds, ETFs and real estate. As fees can add up quickly over time, it’s wise to locate an account with minimal or no charges from banks, credit unions, online brokerage firms or robo-advisors.
SEP IRA
Simplified Employee Pension (SEP) IRAs are tax-deferred retirement accounts designed for business owners to create for their employees, including themselves. Ideal for small businesses and self-employed individuals alike, contributions can vary yearly according to cash flow – as can rollover to new employers’ plans easily.
SEP IRAs follow similar investment, distribution, and rollover rules as traditional IRAs but offer much higher contribution limits for employers. An employer may contribute up to 25% of each eligible employee’s compensation with an annual cap of $66,000 in 2023; employees must be aged 21+ years with three of five years’ service with this employer or nonresident aliens without wages/salaries/personal services compensation in order to be eligible.
Savings IRA
Rules surrounding Individual Retirement Accounts (IRAs) can have a profound effect on how much and when you save, when withdraw money and tax consequences. Therefore, it’s crucial that you understand all your options when opening one.
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is an attractive solution for both small businesses and self-employed individuals, as it enables employers to contribute either a percentage of employees’ compensation, or match employee contributions dollar for dollar up to 3% of pay.
SIMPLE IRA contributions can be made using pre-tax dollars and grow tax-deferred, like Traditional and Roth IRAs; however, withdrawals after age 59 1/2 are taxed as current income and therefore withdrawals taxed as income in their entirety. An IRA CD or Savings IRA may offer more investment opportunities than a 401(k), as they’re often directly offered through major brokerages that provide access to various options like FDIC insured savings accounts, interest-bearing certificates of deposit, and popular mutual funds that enable you to diversify your portfolio for retirement success.
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