Which Type of IRA is Best?
Individual retirement accounts (IRAs) can be an invaluable savings vehicle for individuals. Investors can put aside funds that grow tax-efficiently while enjoying other advantages.
But with eligibility requirements and penalties associated with withdrawing before reaching retirement age, selecting an IRA type can seem intimidating. With some research and guidance in hand, though, making your choice can become easier.
Traditional IRAs allow you to make tax-deductible contributions and defer taxes on investment growth while it remains in your account, however withdrawals over age 73 must pay taxes upon withdrawal and distribution. Deciding between a traditional or Roth IRA depends on both your current income level and expected tax rates in retirement.
Assuming you earn $50k annually and contribute $6,000 annually while in the 22% tax bracket, your deductible contribution saves more than $1320 in federal taxes while offering tax-deferred investment growth of roughly $4,700 over 40 years until age 63. Your money may be invested in mutual funds or ETFs (passively managed index-tracking funds), while self-employed workers and small business owners may choose SEP IRAs which allow higher contribution limits.
Roth IRAs offer you an effective way to save after-tax income and earn investment earnings tax-free, with only distributions prior to age 59 1/2 being subject to taxes. Furthermore, these plans give you greater control over your retirement savings as there is no mandated distribution at certain ages – making Roths the perfect retirement savings vehicle!
Once funded, your Roth account can be invested in stocks, bonds and mutual funds.
Your decision between traditional and Roth accounts should depend on whether your retirement tax rates will be higher or lower, respectively. Furthermore, Roth accounts could help protect you from crossing the income threshold that makes Social Security benefits taxable.
Once an individual leaves their employer and withdraws funds from their retirement account, they have two options for dealing with it: cash out or rollover into another IRA. A rollover typically provides tax savings; federal income taxes will be deferred until withdrawal at retirement, while earnings continue to accumulate tax-free.
Indirect rollovers tend to be preferable due to not requiring the original provider to withhold any potential tax liabilities from distributions.
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SEP (Simplified Employee Pension plan) IRAs offer small business owners and self-employed an easy and straightforward way to save for retirement. Offering generous contribution limits, SEP IRAs provide immediate tax deductions while giving contributors immediate savings potential.
An employer can contribute to a SEP IRA on behalf of themselves and any employees they elect, up to an annual maximum compensation cap of $330,000 per participant. Each contribution amount will depend on a percentage of that participant’s compensation.
SEP IRAs are increasingly popular with self-employed and small-business owners due to their ease of setup and maintenance requirements. If the plan is mismanaged, however, IRS penalties may apply and its tax advantages could be lost altogether; as a safeguard against such penalties the IRS provides an SEP checklist (Publication 4285) as well as self-correction programs to identify errors while operating your plan.
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