In the 21st century, retirement planning is much more complicated than it was just a couple of generations ago. Gone are the days when you could rely on an employer sponsored pension and a healthy social security retirement benefit to provide you with a comfortable retirement. Instead, most people are now forced to develop and fund their own retirement plan. One common funding option for the average retirement plan is an Individual Retirement Account, or IRA. If you are considering the addition of an IRA to your retirement plan, the first thing you need to decide is which type of IRA is right for you.
What Is an IRA?
An Individual Retirement Account (IRA) is essentially exactly what it sounds like. It allows individuals to direct pretax income towards investments that can grow tax-deferred; no capital gains or dividend income is taxed until it is withdrawn. Contributions to an IRA may be invested in many types of securities such as stocks, bonds, money market accounts, and CDs. In essence, an IRA is like a pension that you establish and fund yourself.
Why Are IRAs So Popular?
As employer sponsored pensions became less and less common, and social security retirement benefits failed to keep up with the cost of living, people began to look for better options. As the concept of lifetime employment was replaced by “job-hopping”, the pensions that were once standard with lifetime employment could no longer be counted on to fund retirement. The Social Security retirement system was once intended to provide workers with enough of a benefit each month to live on, albeit not extravagantly. In 2016, however, the average Social Security retirement benefit was $1,348 – an amount that does not come close to providing sufficient income for a retiree to pay his/her basic monthly expenses. Toward the end of the 20th century, as workers began to realize that neither a pension nor Social Security benefits were going to provide sufficient income to retire on, they started looking for ways to fund their own retirement. An IRA was the perfect solution for many people.
What Are the Different Types of IRAs?
As IRAs grew in popularity, they also evolved. Today, there are several different types of IRAs. The most commonly used types of IRAs include:
Traditional IRA – this is the “original” IRA and is what most people think of when IRAs are discussed or mentioned. This type of IRA remains the best option if your income disqualifies you for a Roth IRA. Important points about a traditional IRA include:
- Annual tax deductible contributions are based on income level.
- Withdrawals can begin at age 59½ and are mandatory by age 70½.
- Taxes are paid on earnings when withdrawn from the IRA.
- Anyone with earned income under age 70½ can contribute up to the annual maximum limit.
- Funds withdrawn before age 59½ are subject to a 10 percent penalty unless an exception applies.
- Traditional IRAs may be converted to Roth IRAs by paying income taxes (but no tax penalties) on the IRA distribution before rolling over to a Roth IRA, regardless of income limits.
Roth IRA – a Roth IRA is fundamentally the same as a traditional IRA; however, there are some attractive tax benefits to using a Roth IRA if you qualify to do so. Important points about a Roth IRA include:
- Annual contributions are not tax deductible, but eligibility depends on income level.
- Mandatory distributions at age 70½ are not required.
- All earnings and principal are 100% tax free as long as you follow the IRS rules.
- Traditional, SIMPLE and SEP IRAs may all be converted to Roth IRAs by paying income taxes (but no tax penalties) on the IRA distribution before rolling over to a Roth IRA, regardless of income limits.
- Eligibility is determined based on income
- Principal contributions can be withdrawn any time without penalty as long as the required 5-year holding period is met.
SEP IRA – Simplified Employee Plan – this type of IRA is similar to a traditional pension in that the employer actually establishes the plan and makes the contributions. Points about a SEP IRA include:
- Established by an employer
- Allows the employer to make deductible contributions to a Traditional IRA for participating employees
- Employer decides how much to contribute, up to 25 percent of income (dollar limits also apply)
- Contribution percentages must be the same for all employees
- Employer decides whether to contribute each year; however, if the employer makes a contribution, even to his/her own account, contributions must be made to all accounts.
- Good for small family businesses
SIMPLE IRA – (Savings Incentive Match Plan for Employees) – also similar to a pension’ however, in this type of IRA both the employer and the employee can contribute.
- Designed for small businesses with 100 employees or less
- Allows employees to make salary-reduced contributions and receive matching contributions from their employer.
- Similar to a SEP IRA; however, contributions may be made by both the employer and the employee.
- Employer is required to match the employee’s contribution up to three percent.