Everything You Ever Wanted to Know About Individual Retirement Plans (IRAs)

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Roth IRA vs Traditional IRA written in the notepad.

Choosing a personal individual retirement plan can be one of the most important decisions of your life. Sadly, this is a decision that is often rushed. But with your very future dangling in front of you, it is important to go into this situation armed with the knowledge to make an educated decision.

It can be tough when you have a salesperson waving a 400-page document in your face that you feel pressured to sign. Many people feel forced to make this life-changing decision in a matter of minutes. And when it comes to retirement planning, you cannot rush your decisions.

There is no shortage of options when choosing an IRA. 

Read on to gain a basic understanding of the pros and cons of each type of IRA. Please note that pensions and company-sponsored retirement plans (such as 401ks, 403bs, etc.) will not be discussed in this article.

The Traditional IRA

Traditional IRAs are one of the most common retirement accounts and the most popular of the IRAs. They provide a tax deduction in the year you make your contributions, meaning they lower your taxable income. If your employer already offers a company retirement plan, then you may lose the ability to deduct your traditional IRA contribution as taxable income, as it may be affected by your Modified Adjusted Gross Income (MAGI).

These types of retirement accounts are best suited for workers who do not have an employee-sponsored plan and/or for people who expect to be in a lower tax bracket during their retirement years.

For the tax year of 2020, traditional IRAs allow for a $6,000 annual contribution, or $7,000 annually if you are older than 50. 

With a traditional IRA, your investments will grow tax deferred. Once you make a withdrawal, the amount will be taxed as ordinary income; however, any withdrawals made prior to you turning 59 ½ will be subject to early withdrawal fees and taxes.

The ROTH IRA

ROTH IRAs are the second-most popular of the IRAs. Unlike traditional IRAs, you will not receive a tax deduction when you make contributions; however, all withdrawals will be tax-free once you begin withdrawing when you reach 59 ½.

ROTH IRAs are more common for young investors or those expecting to be taxed at a higher tax rates once they retire. For young people, a ROTH IRA is a logical choice as the investment can grow tax-deferred into a hefty pool of money which will then be withdrawn tax free once they retire. 

If you expect income tax rates will be higher by the time you are ready to withdraw your funds, then it is better to pay the taxes at today’s lower rate. Since you have already paid taxes on these funds, you gain the ability to withdraw the principal funds without further taxation; however, the earnings can not be withdrawn until you turn 59 ½.  

For the tax year of 2020, ROTH IRAs allow for a $6,000 annual contribution, or $7,000 annually if you are 50 years or older.

ROTH IRAs gained their name because the idea of introducing these new IRAs was introduced by U.S. Senator Bob Packwood of Oregon and U.S. Senator William Roth of Delaware. These retirement plans were originally called the IRA Plus before being switched to the ROTH IRA.

The SEP IRA

The Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is an IRA designed for self-employed people and/or business owners. These retirement accounts provide retirement benefits for business owners and their employees.

SEP IRAs have much stricter rules than traditional or ROTH IRAs. They are treated as part of a profit-sharing plan for business owners. Contributions are limited to the lesser of $57,000 or 25% of an employee’s compensation. Compensation up to $285,000 may be considered in the calculation of your maximum contribution. 

Self-employed people are advised to get a trusted fiduciary advisor or tax professional to assist in making the calculations to determine their maximum contribution. In order to calculate the contribution, you must have your net income, along with the deductible portion of self-employment tax and personal contributions. 

The Spousal IRA

The Spousal IRA is designed for married couples who file their tax returns jointly. It is specifically tailored towards a married couple where one spouse does not work, while the other does work. 

The Spousal IRA is not an actual IRA account but rather, it is an IRS policy that allows spouses to contribute to an IRA based on the couple’s combined income. In other words, this is still going to be either a Traditional IRA or a ROTH IRA, which allows for a strategy for the couple that sees the working spouse contribute to the account in the name of a non-working spouse.

Like the other IRAs discussed, in the year 2020 the maximum contribution for a spousal IRA is $6,000 per year or $7,000 if you are over 50 years old. 

The SIMPLE IRA

The SIMPLE IRA plan allows both employers and employees to set aside money into an IRA. These types of IRAs are ideal for small businesses with 100 employees or less and they are beneficial because of the lack of start-up and operating costs which conventional retirement plans often have.

The acronym SIMPLE stands for ‘Savings Incentive Match Plan for Employees’.

With a SIMPLE IRA, both the business and the employee may contribute to the plan. This includes a matching contribution up to 3% of the employee’s compensation and a 2% non-elective contribution on up to $285,000 in salary per person for eligible employees who do not invest in their accounts.

Employees may contribute up to $13,500 in 2020. If the employee is 50 years or older, the plan-taker can make ‘catch-up contributions’ of up to $3,000 in addition.

One advantage to the SIMPLE IRA is employees can transfer or withdraw the entire balance when they leave the company. If the employee stays with the company, the investment will grow tax-deferred until the withdrawals are made. Funds withdrawn are taxed as regular income. If funds are withdrawn prior to the age of 59 ½ then there may be surrender charges, taxes and/or penalties.

The Self-Directed IRA

A Self-Directed IRA is a type of IRA such as a Traditional IRA or a ROTH IRA, with the main difference being the types of assets which can be owned or invested in this type of retirement account.

For the most part, regular IRAs are typically invested in stocks, bonds, mutual funds or other common investments. The Self-Directed IRA offers more possibilities such as real estate or privately held companies. The advantage is for investors who are seeking higher returns and greater diversification.

You can actually buy rental properties or invest through real estate platforms such as Crowdstreet or Fundrise via a Self-Directed IRA. While additional options are available to you, the IRS still forbids certain types of investments with a Self-Directed IRA, such as collectibles and life insurance.

Your annual contributions can be made to your Self-Directed IRA and you can also convert any amount of funds available in your existing IRA types into a Self-Directed IRA.

The Non-Deductible IRA

The Non-Deductible IRA is designed for people who make too much money to deduct IRA contributions. A Non-Deductible IRA is a retirement plan you fund with after-tax dollars.

The main difference is that you cannot deduct contributions from your income taxes, as you can with Traditional IRAs.

Many investors turn to these options because their income is too high for the IRS to let them make tax-deductible contributions to a regular IRA.

A common strategy with this type of IRA is to eventually convert it into a ROTH IRA. The investor pays the taxes on the earnings the account makes over time up to the point of the conversion, in exchange for tax-free withdrawals in the future. The savings generated can be huge if this strategy is utilized properly.

The Rollover IRA

A Rollover IRA is simply a personal retirement account which contains investments which were transferred (or rolled over) from an employer retirement account. These types of IRAs are best suited for people who have left their job which they previously had an employer retirement account set up at. 

With a Rollover IRA plan, you can preserve the tax-deferred status of your retirement assets, without paying current taxes or early withdrawal penalties at the time of transfer.

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