If you’re looking to save for later in life, an Independent Retirement Account (IRA) might be the right choice for you. What’s the main difference between an IRA and other retirement savings accounts, such as pension plans or 401(k)s? Well, there are many differences, but the biggest one is that IRA contribution limits are set by the IRS, whereas 401k limits are set by the employers.
There’s a common myth in circulation that might have you believe you need to choose one account or another. This isn’t true – you can open and manage both an IRA and 401k. Your IRA can be actively or passively managed and made up of mutual funds, stocks, bonds, bank deposit accounts, and most other types of investments. There are many different types of IRA plans, and the best one for will probably depend on your own unique situation. Let’s take a look at some different IRAs, and their distinct features, to see how you could benefit from opening an account.
- Traditional IRA
Traditional IRAs are advantageous because they are deductible, meaning that any contributions can be written off as a tax deduction at the end of the year. These deductions reduce your gross income, and in turn reduce your tax burden. Both contributions and earnings are tax-deferred until the funds are distributed upon retirement. A Traditional IRA benefits individuals whose tax rate will decrease between the time of deposit and when the money is withdrawn. - Nondeductible IRA
True to its name, a Nondeductible IRA does not allow you to write off contributions on your tax return. Since you’re already paying taxes on these contributions, at the time the funds are dispersed, you’ll only pay taxes on the account’s earnings. The major advantage of this type of IRA is the tax-deferred growth of contributions and earnings. Furthermore, nondeductible IRAs provide an investment option for individuals who do not meet the eligibility criteria for a Traditional IRA. - Roth IRA
Roth IRAs have become more popular in recent years, but you cannot open an account if you exceed a certain income level. Contributions to this account are taxed as income in the year they are deposited – similar to the nondeductible IRA – so contributions cannot be taken as tax deductions. However, this means that the funds cannot be taxed at the time they are distributed. After the age of 59, all or part of the Roth IRA funds can be withdrawn income tax-free. In certain instances, the IRS will allow early withdrawals for qualified purposes, like purchasing a home or paying for higher education, as long as the account has been open for at least five years.
These IRAs are created by you, the contributor, and pair excellently with additional retirement savings plans. Any individual who has earnings from salary or wage income is eligible to establish an IRA. You can set up one of these tax-sheltered accounts at a bank, investment firm, or insurance company. Additionally, some employers might offer you an IRA account through their business. There are two types of employer-sponsored IRAs:
- SEP IRA
A SEP (Simplified Employee Pension) IRA is available for self-employed individuals or small business owners. Contributions, which are tax-deductible for the business or individual, go into a Traditional IRA held in the employee’s name. Employees themselves are not eligible to contribute to this account. The contributed funds are tax-free until the time of withdrawal, which, like other IRAs, cannot be dispersed until retirement or 59 years of age. - SIMPLE IRA
A SIMPLE (Savings Incentive Match Plan for Employees) IRA allows employees to contribute part of their pre-taxed compensation to the account, unlike an SEP IRA. Employers are then required to either make matching contributions or non-elective contributions. All employees are vested within a SIMPLE IRA Small businesses who maintain no other retirement account options and employ 100 employees or fewer are eligible for this plan.
In the end, whichever IRA you choose can help you have a happy and successful retirement later in life. To make yourself more comfortable later, be sure to start saving now.