2017 Guide: What Is an IRA or a Roth IRA? 10 Things to Know about IRAs (Self-Directed, Simple, Inherited, SEP, and other IRAs)
The United States is grappling with the possibility of a retirement crisis.
As life spans increase and the number of employer-sponsored retirement plans decline, the country is facing a future in which a large number of the population will not have the physical or financial means to support themselves.
Relying on Social Security payments to get you through retirement is simply not enough. Social Security payments are meant to act as a supplement to other retirement income, such as savings, property, or a traditional IRA.
Living comfortably in retirement requires some serious planning long before you finish working.
You may be sitting there thinking, “I don’t even know what a traditional IRA is!” If that’s the case, chances are you are at a loss about what is a Roth IRA, a SEP IRA, a SIMPLE IRA, or an inherited IRA.
And with so many options, you may be overwhelmed at the thought of figuring out which IRA is right for you.
This article will go through the individual retirement plans (IRAs) available to you.
It will provide a breakdown of what you need to know about the available options including a traditional IRA, SEP IRA, and SIMPLE IRA. It will also go over the details regarding inherited IRAs and rollover IRAs.
In addition to clear descriptions of the features and details of each IRA, this article will provide some pointers for deciding which IRA is best for you, whether it’s a traditional IRA, SEP IRA, or SIMPLE IRA.
Taking the time to research your options will set you up to have all the information you need to make the best choices for your retirement planning.
Image Source: Things to Know about IRAs
While it is definitely better to start saving for retirement sooner rather than later, there is no time like the present, even if you are approaching retirement, to get proactive about your retirement savings. This article on everything from inherited IRAs to how to start a Roth IRA will help you get started with individual retirement accounts.
See Also: 401K Withdrawal? Before You Do, Review the Limits, Penalty, Early Withdrawal Facts
1. What Is an IRA? The Individual Retirement Account
What is an IRA? An IRA is an account set up by a financial institution on behalf of an individual that allows them to save for retirement. It is different from a regular savings account because it enjoys specific tax advantages.
What is an IRA’s tax advantages? The money that is put in an IRA (including any stocks, bonds, or mutual funds) can grow on a tax-deferred basis.
This means that you are not required to pay taxes either at the time of contribution or at the time of withdrawal. When you pay taxes differs based on the individual retirement plan that you choose, whether it’s a traditional IRA, Roth IRA, or any other.
Naturally, you cannot contribute an unlimited amount of funds into an individual retirement account. That would provide too much opportunity for tax-free growth. So what is an IRA’s limits in this case?
Contribution limits (and in some cases, eligibility requirements) differ based on the account and are set by the Internal Revenue Service (IRS). We will get into these various requirements as we discuss each different account.
2. A Traditional IRA Pays Taxes on Withdrawals (What is the Difference When Withdrawing from a Roth IRA?)
Individual retirement accounts enjoy tax advantages, and these tax advantages differ based on the account.
Contributions to a traditional IRA are tax deductible, and they can grow in the account on a tax-deferred basis, meaning you are not required to pay taxes until you withdraw the funds. This means that you experience the tax advantage at the time of contribution.
What is a Roth IRA’s tax advantage? A Roth IRA experiences the tax advantages at the time of withdrawal. When you make contributions to a Roth IRA, these contributions are not tax deductible.
This means that you are making these contributions with your after-tax income. Your money can grow tax free in the Roth IRA, and when you are withdrawing from your Roth IRA, that income is yours to enjoy free from tax as well.
All-in-One Change Management Tools
Top Rated Toolkit for Change Managers.
Get Your Change Management Tool Today...
3. Choose a Traditional IRA if You Think You Will Make Less in Retirement
If you are thinking about how to start a Roth IRA, but you are also flirting with the idea of contributing to a traditional IRA, here’s an important consideration to make: your current income versus your expected income in retirement.
It works like this. If you choose to open a traditional IRA, you experience the tax advantage at the time of the contribution, but you will be required to pay taxes on your IRA distribution in retirement.
If you think you will have a lower income in retirement, this may also mean you will have a lower marginal tax rate, meaning you will be required to pay less taxes in retirement. In this way, choosing to defer your taxes until then saves you money.
On the other hand, if you think you will be making more in retirement thanks to a combination of your assets and retirement savings, then a Roth IRA is recommended.
When you are learning how to start a Roth IRA, your future income is something you should really think about. If you make more money in retirement, your marginal tax rate will be higher and you will be required to pay more income tax.
What is a Roth IRA’s benefit in this regard? You won’t have to pay any taxes when withdrawing from a Roth IRA, even if you are in a higher tax bracket.
Don’t Miss: How to Save for Retirement | Best Ways to Save for Retirement
4. A Rollover IRA Is an Option for Those Who Want to Switch from a Qualified Retirement Plan
Are you already participating in a qualified retirement plan instead of an individual IRA? A qualified retirement plan is a retirement plan that is set up by an employer in order to benefit their employees.
It is mutually beneficial for employers as they enjoy a tax break for their contribution, plus they are more likely to draw desirable candidates if they offer such a retirement plan at their company.
Whereas a traditional IRA and other IRAs can be opened individually, qualified plans have to be opened by an employer. The most popular qualified retirement plan is the 401(k).
But what do you do if you leave the job where you had a 401(k)? You have a few options when you leave a job: you can keep your money in the 401(k) at your old job, withdraw the money (which is not usually recommended due to potential penalty fees from the IRS), transfer the balance to a 401(k) at your new job, if applicable, or rollover the funds into a rollover IRA.
Some people may choose to rollover their 401(k), for instance, into a rollover IRA. If you choose a rollover IRA, you enjoy more diversity in your investment choices and lower fees than you would with a 401(k). 401(k) plans come with more limitations on the types of investments you can make in them and, at times, pricier management fees.
Image Source: What Is an IRA or a Roth IRA
5. You Can Include Even More Investments in a Self-Directed IRA (More Than a Traditional IRA or Roth IRA)
A self directed IRA operates much like other IRAs, including a traditional IRA or a Roth IRA. You gain the same tax advantages and can include a number of investments. The difference is that self-directed IRAs allow for more investments that are not traditionally permitted in other IRAs.
This is because many IRA custodians (the financial institution through which you open your IRA) may have specific limitations on what kinds of investments you can put in your IRA. In other words, these financial institutions with self-directed IRAs offer “alternative investments.”
These alternative investments include investments like private placements, tax lien certificates, real estate, and more in addition to the traditional IRA investments like stocks, bonds, and mutual funds.
6. Small Business Owners Can Set Up a SIMPLE IRA for Their Employees
Small business owners may want to offer perks to draw in quality employees but struggle to offer the same kind of retirement plans or 401(k) plans that bigger companies can. The SIMPLE IRA is an alternative.
With a regular or traditional IRA, only the account holder can make contributions. With a SIMPLE IRA, which stands for the Savings Incentive Match Plan for Employees, both the account holder and the employer can make contributions.
In fact, the SIMPLE IRA is set up by the employer for the employee. Small business owners who set up a SIMPLE IRA on behalf of their employee or employees can make additional requirements or stipulations regarding who qualifies for participation.
Additionally, if a small business owner is the sole proprietor, they can set up a SIMPLE IRA for themselves as well. Employees can contribute way more money to a SIMPLE IRA than they can to a traditional IRA. They can contribute up to $12,500, and employees 50 years of age or older get a $3,000 additional catch up amount.
The employer must also choose from contributions options (non-elective contributions or elective contributions) set by the IRS. They can change their SIMPLE IRA contribution choice each year and must inform their employees how much they will be contributing at the start of the new calendar year.
Related: Ways You Can Retire Early (Detailed Early Retirement Planning Guide)
7. You May Not Be Eligible for a Roth IRA (What Is a Roth IRA’s Eligibility Requirements?)
What is an IRA’s eligibility requirements? Can anyone contribute to a traditional IRA or Roth IRA.
You can set up a traditional IRA if you have earned income (this includes income from an employer, earnings as a sole proprietor, and alimony.) An example of income that is not considered earned income is money earned on investments. So long as you meet this requirement, you can contribute $5,500 annually and an extra $1,000 if you are 50 years of age or older.
What are a Roth IRA’s eligibility requirements? What are a Roth IRA’s rules on who can contribute? Admittedly, a Roth IRA is a bit more strict about who can contribute. There is an income cap after which individuals are no longer eligible to contribute to a Roth IRA, and this is determined on a yearly basis. Additionally, even if you do qualify, the amount you can contribute is determined by a sliding scale based on your income and marital status.
8. You Can Do a Roth IRA Conversion to Switch from a Traditional IRA to a Roth IRA
What is Roth IRA flexibility if you want to convert your existing IRA? Some people open a traditional IRA because they are not eligible for a Roth IRA. There used to be the option to convert to a Roth IRA if one’s income was under a certain amount, but the income cap on Roth IRA conversions was recently lifted, allowing people to make the switch so long as they pay the taxes on the conversion.
In this case, there is the option of a Roth IRA conversion. So, what is a Roth IRA conversion and what is an IRA’s flexibility when it comes to converting it to a Roth IRA? You can switch from a traditional IRA to a Roth IRA, pay taxes on what is technically a withdrawal from your earlier IRA, and if you deposit the funds into a Roth IRA within 60 days, you are not required to pay the early withdrawal penalty.
One reason people do this is for long-term tax gains. If your income drops in a given year, you can do a Roth IRA conversion from a traditional IRA that year, pay a lower tax rate because of your reduced income, and then benefit from the long-term tax gains you get from a Roth IRA.
9. An SEP IRA Provides Retirement Planning and Perks for Both Sole Proprietors and Employers
An SEP IRA, or Simplified Employee Pension plan, is a variation of the IRA that can be used by employers and self-employed individuals. They are usually opened by sole proprietors and freelancers. The employer makes contributions to this Simplified Employee Pension plan on behalf of workers that are included.
The employer is not required to make contributions every year, but when they do, they must make it to their included employees’ SEP IRAs as well.
The employer gets a tax deduction, and the employees are not required to pay any taxes on this contribution. That being said, distributions or withdrawals from a SEP IRA are taxed.
The maintenance fees and other costs associated with setting up and administering an SEP IRA is less than the money spent administering traditional, qualified accounts like a 401(k).
10. Inherited IRAs Are a Little Trickier to Manage
Most people list a beneficiary for their retirement savings if they pass away before they can use it or spend it all. An inherited IRA can be a bittersweet gift, but it can also be a pesky gift to manage, particularly if you wish to stretch out the account to continue to enjoy tax-free growth.
Before doing anything with an inherited IRA, make sure you speak with a financial advisor. The IRS is not particularly forgiving of mistakes, so if you make any moves and then find you have to pay taxes (when it could have been avoided) you will not have much luck convincing them to let you start the process over.
Before moving the money from an IRA to another account, speak to a financial advisor.
This is important because an inherited IRA is a tricky mix of estate plan and tax planning, not to mention your own financial planning. Moreover, if the deceased’s beneficiary form was not properly filled out, the flexibility of the IRA you’ve inherited is limited. Speak to a financial advisor to find a solution that works best for you.
Popular Article: The Best States to Retire in the U.S. (Review of the Top Retirement States)
Free Wealth & Finance Software - Get Yours Now ►
There Are a Number of IRA Options: Choose Wisely!
What is an IRA or a Roth IRA if not a way for you to save for retirement? That is what these accounts are meant to do at the end of the day, and these options exist so that retirement saving is accessible to as many people in as many life situations as possible.
Explore your options or book an appointment with a financial advisor to go over your options whether you want a traditional IRA, a Roth IRA, have to manage an inherited IRA, or are looking for a rollover IRA. Take steps toward ensuring your financial security and comfort in retirement.
Read More: Do I Have Enough to Retire? Find Out if You Have Enough Money for Retirement
AdvisoryHQ (AHQ) Disclaimer:
Reasonable efforts have been made by AdvisoryHQ to present accurate information, however all info is presented without warranty. Review AdvisoryHQ’s Terms for details. Also review each firm’s site for the most updated data, rates and info.
Note: Firms and products, including the one(s) reviewed above, may be AdvisoryHQ's affiliates. Click to view AdvisoryHQ's advertiser disclosures.