Roth and traditional IRAs may be the de facto king and queen of the retirement account prom, but there are other attractive options savers shouldn’t overlook.
Although they’re lesser known, Spousal, SEP, SIMPLE and other types of individual retirement accounts offer the same — and sometimes better — tax-saving, money-growing benefits. Your choice of IRA can vary based on your income, employment status, workplace offerings and other factors.
Here are the basics on seven types of IRAs to help you decide which one (or ones) will deliver the most financial advantages.
1. Traditional IRA
The elder statesman of IRAs, the traditional IRA remains the most popular of the individual tax-advantaged retirement savings accounts, according to Investment Company Institute data. The classic features include:
- An upfront tax break of up to $6,000 in 2020, the same from tax year 2019 (plus an extra $1,000 catch-up contribution if you’re age 50 or older): Contributions may be deductible (depending on your current income and tax filing status and the availability of a workplace retirement plan to you and/or your spouse), thus lowering your taxable income for the year.
- Investment earnings are not taxed as long as the money remains in the protection of the account.
- Withdrawals in retirement are taxed at your tax rate at that time.
Best for: Those who are in a higher tax bracket now than they think they’ll be in during retirement, as well as workers who do not have access to (or are not eligible to contribute to) a workplace-sponsored retirement plan. Here is our rundown of the best IRA accounts.
2. Roth IRA
The Roth IRA provides a nice tax-saving counterbalance to the traditional IRA. Here are its key features:
- While contributions are not deductible — meaning there’s no upfront tax break — withdrawals in retirement are completely tax-free.
- Eligibility to contribute to a Roth is based on your income. Contribution limits are the same as they are for the traditional IRA, but if you earn too much to contribute to a Roth, there’s a completely legal way to open one anyway via a backdoor Roth.
- Roth IRA withdrawal rules are more lenient, allowing tax- and penalty-free withdrawals of contributions at any time. Taxes and penalties apply to withdrawing earnings before retirement, with a few exceptions.
Best for: Savers who anticipate being in a higher tax bracket in retirement, to take advantage of those tax-free withdrawals. A Roth is also a better choice than a traditional IRA if you might need to access some of the money before retirement age, although we discourage dipping into retirement savings early. Interest piqued? Here’s a rundown of the best Roth IRA accounts.
3. SEP IRA
The first three letters stand for simplified employee pension. Even though it’s a type of traditional IRA, it is set up and funded for employees by an employer, who gets tax benefits for the effort. Within a SEP IRA, earnings grow tax-free and distributions in retirement are taxed. Other highlights:
- Annual contribution limits are much higher than what’s allowed in other tax-favored retirement accounts — the lesser of up to 25% of employee compensation or $57,000 in 2020, up from $56,000 in 2019. If you’re self-employed, your contribution/deductibility limits may be different. (See See IRS publication 560.)
- An employer must contribute equally (on a percentage basis of salary) to all employee accounts, including their own
- Contribution size may vary year to year based on the business’s cash flow but must always be equal for all eligible workers
- Employees are not allowed to contribute to the plan via salary deferral; must have worked for the employer in at least three of the last five years; and must have earned at least $600 in compensation during the year to be eligible
- Sole proprietors (aka Employee No. 1 and only) can open a SEP IRA for themselves
- Catch-up contributions for workers 50 and older are not allowed
Best for: Small-business owners who want to avoid the startup and operating costs of a conventional retirement plan, as well as the ability to supersize their retirement stash and get a tax deduction on any contributions made for employees. Just be aware that if you’re both the employer and employee, it’s important to follow SEP IRA rules to avoid running afoul of the IRS.
4. Nondeductible IRA
Remember how we said that traditional IRA contributions may be tax deductible? If they’re not, that doesn’t mean you’re not allowed to fund an IRA at all. It just means that the deductibility issue is moot. The main things to know about a taxable IRA:
- Contributions are made with after-tax dollars and, as the name makes clear, are not deductible. But …
- You still get the perk of tax-deferred growth on earnings within the account
- Taxes in retirement are due on any earnings growth you withdraw, but not the principal, since the account was funded with already taxed dollars
Best for: Those who do not qualify to contribute to a Roth IRA or a deductible IRA.
5. Spousal IRA
IRS rules state that a person must have earned income to be eligible to contribute to an IRA. But there’s a workaround for married taxpayers: If one half of the twosome isn’t working — or brings in a very low income — you can both contribute to your own separate IRAs (either Roth or traditional).
- Couples must file a joint tax return and have taxable compensation to be eligible
- Contribution limits are based on whatever the working spouse is allowed, up to $6,000, or $7,000 for those 50 or older. In 2019 the contribution limits were the same.
- The total amount contributed to both IRAs must be the lesser of your joint taxable income or double the annual IRA contribution limit (e.g., $12,000 for those under 50 in 2020 and 2019)
- The account can be funded with money from either spouse’s earnings but must be opened in the nonworking spouse’s name using his or her Social Security number
Best for: Low-income or nonworking individuals married to someone who has earned income.
6. SIMPLE IRA
The SIMPLE IRA (Savings Incentive Match Plan for Employees) is similar in many ways to an employer-sponsored 401(k). It primarily exists for small companies and the self-employed. Unlike the SEP IRA, employees are allowed to contribute to the account via salary deferral. Some plans even allow an employee to select the financial institution they want to use to hold their account. Tax-wise, SIMPLE IRA rules are much like those that apply to traditional IRAs. Other considerations:
- Contribution limits are lower than that of a 401(k) — $13,500 versus $19,500 for the 2020 tax year and $13,000 versus $19,000 for 2019
- Employers are generally required to kick in up to a 3% matching contribution or a fixed contribution of 2% of each eligible employee’s compensation
- To qualify to participate in a SIMPLE IRA, an employee must have earned at least $5,000 during any two years before the current calendar year and expect to receive at least that amount in the current year
- Unlike the SEP, catch-up contributions are allowed: If you’re 50 or older, you can save an additional $3,000
- Unlike most workplace plans, participants can roll the money from the account into a traditional IRA after two years of participation in the SIMPLE IRA plan
- Early withdrawals from a SIMPLE IRA within the first two years of contributing to the account may be subject to a punishing 25% penalty (on top of regular income taxes)
Best for: Smaller companies with fewer than 100 employees. If you’re self-employed, you may be better off opening a SEP IRA for the higher contribution limits.
7. Self-directed IRA
Self-directed IRAs (in the traditional and Roth flavors) are governed by the same eligibility and contribution rules as traditional and Roth IRAs except for one big difference: What goes in the account.
The other IRAs covered in this article typically limit investments in the account to common vehicles like stocks, bonds and mutual funds. In a self-directed IRA, you’re allowed to own assets such as real estate, hard assets like gold and privately held companies. Some must-knows:
- Setting one up requires a trustee or custodian who specializes in the less typical types of investments you’re interested in holding in the account
- The IRS does not allow holding things like collectibles and life insurance in the account
- There are many prohibited “self-dealing” transactions within a self-directed IRA (e.g., mowing the lawn or fixing the faucet in a rental property owned in the IRA) that the IRS deems equivalent to taking a distribution. These can trigger taxes and penalties on the entire account.
Best for: Experienced investors who want access to alternative investments such as real estate and nontraditional businesses. While there are benefits to using this type of account to save for retirement (mostly the potential for higher returns), do not pass go until understanding the risks of self-directed IRAs.
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