Do you know about the different types of IRAs? No matter how old you are, it is never too early to think about retirement. Remember, the small decisions that you are taking today can have a decisive impact on your future. While your employer might already be thinking about your retirement fund, you should know that it will likely not be enough. Consequently, it would help if you think about an IRA.
What Are The Different Types Of IRA?
What Is An IRA?
It stands for Individual Retirement Account (IRA) and is a tax-advantaged investing tool. With an IRA, you save funds for your retirement. It includes financial products such as stocks, ETFs, and mutual funds. There are several types of IRAs, depending on the person’s employment position. In this article, we will take a look at some of them.
Types Of IRA
Now that we have talked about what an IRA is, we can discuss the types of IRAs. These are:
Traditional IRA
The Basics
In several cases, the contributions to traditional IRAs are tax-deductible. For example, if you put in $6000 in an IRA, the taxable income decreases by contributing. When you take out money from your account in retirement, you have to pay taxes on the amount at the ordinary income tax rate. Annual individual contribution in this account cannot be more than $6000. However, if you are 50 or above, you can contribute $7000 per year.
What changed in 2021
For 2021, the IRS has left the contribution limits unchanged. However, they changed the phase-out range from $104,000-$124,000 to $105,000-$125,000 for married couples. For singles, it was previously $65,000-$75,000 and it is now $66,000-$76,000.
The Particularities
When a traditional IRA holder reaches the age of 72, they must begin taking required minimum distributions. This policy depends on the account size and life expectancy. If an individual fails to comply with the given set of rules, the institution can penalize them by 50% of the amount needed for distribution. The Setting Ever Community Up for Retirement Enhancement (SECURE) Act in 2019 eliminated the minimum age required for contributing towards an IRA. Now, anyone of any age can do so.
Roth IRA
The Basics
Among the different types of IRA, this one is popular. Contributions to Roth IRA are not tax-deductible, but the distributions are tax-free. You can use your after-tax dollars to contribute to Roth IRA but do not have to pay taxes on investment gains. The good thing is when you retire, you can withdraw from the account without paying more taxes on the withdrawal.
The Difference To A Traditional IRA
Unlike traditional IRAs, Roth IRAs do not have RMDs. If you don’t need the money, you don’t have to withdraw it. You can also contribute to the IRA as long as you have income. It doesn’t matter what your age is. The limits are the same as for the traditional IRA. $6000 if you are under 50 and $7000 if you are 50 or older.
The Limitations
With a Roth IRA, there are income limitations. The phase-out range is between $124,000 and $139,000 for single and between $125,000 and $140,000 for married couples.
Sep IRA
This type of IRA is for self-employed individuals, such as freelancers or contractors, or even small business owners. It stands for simplified employee pension and has the same taxation rules as the traditional IRA. For 2020, the SEP-IRA contribution limits are to 25% of compensation, $57,000, whichever is lower. In 2021, the figure will go up to $58,000. Business owners who SEP IRA’s for their employees are allowed to deduct the contributions. However, company employees cannot contribute to their accounts, and the amount is tax-deductible once individuals start to withdraw it.
Simple IRA
Of the different types of IRA, this one is for small businesses and self-employed individuals. The term “simple” means “savings incentive match plan for employees.” The taxation rules are the same as those followed by the traditional IRA. However, in Simple IRAs, the employee is allowed to make contributions to accounts as well. The contributions are tax-deductible, which means the business or the employee falls into the lower tax bracket. The simple IRA employee contribution limit is higher at $13,500, and the limit for people aged 50 and above is lower at $3000.
Why Should You Invest In An IRA?
Experts argue that you will need up to 85% of the pre-retirement income in retirement as living costs go up. The traditional 401k, though the right choice, is not sufficient to keep you comfortable for the rest of your life. An IRA can help you to:
- Accumulate your current savings in an employment plan sponsored by your employer
- You will have access to more investment opportunities. Something that is not possible by the 401k
- You can also take advantage of the tax brackets and invest smartly
Which One Should You Choose?
Go For The Traditional IRA
With a traditional IRA, the tax break is upfront. That is why most people choose to invest in it. It is a considerable advantage, especially for those who earn more and pay a higher tax amount. Also, it is an incentive for those who might not consider investing in retirement.
Or Choose The Roth IRA
In the short term, it makes it cheaper to save for retirement because the tax savings each year reduce how much you will contribute. However, once you do retire, you will have to face the tax burden you had been evading for so long. This circumstance means you can’t get too comfortable with the tax break you receive at the start. It is for this reason that Roth IRA is better. In the end, you will not have to worry about tax taking up a significant proportion of your income.
The Bottom Line
Now that we have discussed the different IRA types and told you about the ups and downs, you should start thinking about opening such an account. In the end, it’s a lifetime choice, and research is the key. If you’re well informed and prepared, you’re good to start now. If not, you can also look for a financial advisor who will help you with your choice. Remember, the cost of living is going up, and you will need to have a good amount stored away if you want to live comfortably after your retirement.
