While many look forward to the golden years of retirement, this period of time can bring a list of unknowns. Some of these unknowns include financial security, overall health, and simply, what to do with all of the free time. Even though it may seem impossible, the financial security of the future doesn’t have to be a part of this list. Way before retirement comes, many are opting for an individual retirement account (IRA), instead of the traditional employer-provided 401K plan. Although there are several types of IRAs that come with their individual incentives, no one should overlook these money-saving benefits.
- An IRA is a vehicle that allows you to save and invest your savings while getting taxes on your earnings deferred
- An IRA can be used to invest money that hasn’t been taxed, or in the case of a Roth IRA, money that has already been taxed
- The Simplified Employee Pension IRA allows both the employee and employer to contribute to the fund. It has higher limits, allowing for larger investments
- A Spousal IRA allows a couple to invest in the same IRA at the same time
- A Self-directed IRA allows for a greater range of investment options but follows the same general rules when it comes to taxation and distribution
Understanding an IRA
An IRA is an account arranged by a financial institution that makes it possible for an individual to save up for retirement. The savings are invested and benefit from tax-free or tax-deferred growth.
An IRA has become a more attractive option because of the perks it offers. Unlike a 401k plan, this income can be used flexibly, allowing investment in a variety of different ways. This means there is more control as to how the deposited money is used. An account can be opened at any financial institution like banks, insurance companies, brokerage firms, and mutual fund companies.
An IRA, at times, can allow for self-directed investments in just about any category such as stocks, CD’s, bonds, mutual funds, or government bonds. With this specific type of investment, paying taxes on the invested money can be put off until after retirement.
While there is a lot of excitement with being able to control invested money, there are some factors to consider. To choose the right IRA, consider the income potential, the tax bracket, and even the age of the owner of the account.
Understanding how the money is going to be used can help decide which IRA is best. For example, some circumstances allow for some money in an IRA to help pay for medical bills, health insurance premiums, higher education costs, or even to help a first time home buyer. Understanding the withdrawal options, and penalties, if any, is important. So, the choice lies with which type of IRA will supply the best financial advantages.
The Classic IRA
Traditional IRAs are also known as the classic choice because you get a tax break right out of the gate. When it was introduced by Congress in the mid-’70s by the Employment Retirement Income Security Act, it was a way to inspire people to save for their retirement by creating special tax treatment on the saved money. With eligibility requirements, the funds could be tax-deductible or grow tax-deferred. This type is great for people who may start off in a higher tax bracket than they will be in when they retire or for workers who aren’t eligible or don’t have access to a retirement plan at their job.
Traditional IRAs remain the popular choice because with the contributions being deductible, this lowers the taxable income for the year. So as long as the money stays in the account, the investment earnings are not taxed. And when it is retirement time, the withdrawals are taxed at the current rate at that time.
The Roth IRA was part of the Taxpayer Relief Act, designed for people who expect to be in a higher tax bracket when they retire. This kind of IRA may be the way to go if access to the money before retirement. Granted, there may not be any up-front tax breaks, but any of the withdrawals in retirement are tax-free.
The benefits of this type of account are, as the funds grow, there is never any tax, no matter what kind of funds they are ( i.e capital gains, interest or dividends). So before contributing taxes are already paid which, in the end, may aid in being in a higher tax bracket later in life. The Roth IRA allows for more flexibility with the funds that are contributed early on like an emergency fund, or later on allowing for more tax break perks.
Important IRA Options to Consider
Traditional IRAs and Roth IRAs undoubtedly are the typical choice for most people. Yet, within those leading options, there are subcategories that aren’t widely known, but can be better options. As with anything, thorough research and considering the savers’ situation can assist in choosing the right IRA to gain all of the benefits. Some of the other options are:
A Nondeductible IRA
This gets funded by after-tax dollars that are not deductible. This IRA still gives the perk of growth on earnings in the account to be tax-deferred. Since the account was filled with dollars already taxed, the only taxes that get paid are on the principal, not on the money that’s withdrawn.
The Simplified Employee Pension (SEP) IRA
This is similar to a traditional IRA, but it is funded and set up by an employer for employees (employers get tax benefits for contributing). There are much higher annual contribution limits in comparison to other tax-favored retirement plans. Both employees and the employer give an equal contribution based on a percentage of the salary. What is nice is that although the contribution size may vary from year to year because of the cash flow of the business, it is always an equal contribution for employees who are eligible. However, employees can’t contribute to the plan by salary deferral.
This type of IRA is best for small business owners wanting to avoid certain startup costs with traditional plans. It will also allow for a tax deduction on contributions employees make, and a chance to stockpile the retirement stash. A word of caution for sole proprietors is although they can open a SEP IRA for themselves, research needs to be done to avoid run-ins with the IRS.
The Savings Incentive Match Plan for Employees IRA Plan ( aka the SIMPLE IRA)
A favorite for smaller companies and the self-employed. It is similar to 401K plans provided by employers, where they match a certain percentage or have a fixed contribution, yet savers can convert it into a traditional IRA after two years. The difference between this plan and a SEP IRA is that employees can contribute to their accounts by salary deferral. Some plans also let an employee choose which financial institution they would like to use for their account.
The Spousal IRA
A common way to work around the IRS rule that a person must have earned income in order to open an IRA. With a Spousal IRA if your spouse isn’t working, or brings in a significantly lower income, both can contribute to their own separate IRAs. These can be either a traditional IRA or a Roth IRA. With this type of IRA, there are very specific guidelines.
To be eligible, the couple must file their taxes jointly and have taxable compensation. The limits for contribution are based on what the spouse who is working is allowed. The amount contributed to each account falls in the category of one of two things. It has either double the annual IRA contribution limit, or the lesser of the joint taxable income. Finally, the account has to be opened in the lower-income or nonworking spouse’s name (and using their social security number). Yet, the account can be funded by either spouse’s earnings.
The Self-directed IRA
Although it may be governed by the same rules as traditional and Roth IRAs, the one big difference is what goes in the account. Geared toward the more experienced investor, the self-directed IRA comes with many perks, but specific rules to follow. A trustee or custodian whose specialty is less-than-typical investment accounts is required. The previous IRAs generally limit investments in the account to common things like bonds or stocks. Whereas, the self-directed IRA opens the door to being able to own a variety of assets. These alternative investments can be something like real estate or gold which are hard assets, or non-traditional businesses like privately held companies.
The Choice Is Yours
There seems to be a world of endless investment and savings possibilities when considering an IRA as the way to build the retirement nest egg. So many choices lie in whether or not a saver wants to pay taxes now or later, have access at any given time, or not be able to touch contributions, ending in a different tax bracket, or a change in the type of assets they may have in later years. All of these options are taken into consideration when deciding what type of lifestyle will be lead during retirement and if Social Security will be apart of the funding or not. IRAs were designed to help individuals make these tough future financial plans a bit easier to envision. If you’d like to learn more about trading and how it can benefit your investment portfolio, take advantage of a free educational webinar or ebook to learn more about trading.