Apart from 401(k) plans and other workplace-sponsored plans, Individual Retirement Accounts, or IRAs, are another method of tax-advantaged retirement saving. They allow you to save money for retirement on a tax-free or on a tax-sheltered basis.
Many types of IRAs exist. Each kind of IRA comes with its own benefits, advantages, rules, and contribution limits. Should you set up an IRA through a brokerage firm, you can invest your funds in stocks, bonds, mutual funds, real estate, and various other government-approved assets.
If you are researching your IRA options or for a rollover from an employer-sponsored retirement savings plan, it’s good to know the basics. Let’s discuss some different types of IRAs that are available.
Traditional IRA
In a traditional IRA, you can deposit pre-tax earnings to accumulate money for retirement. You contribute funds and receive a tax deduction. The money is tax-sheltered until you start taking it out at retirement time.
Here, the rationale is that you won’t make withdrawals until you cease working. Thus the distribution you receive from the IRA would be subject to a lower tax rate. The traditional IRA does have deterrents against withdrawals before reaching retirement, though. If you tap into your nest egg before you are 59.5 years old, there is a 10% penalty on top of the other taxes due. You must begin withdrawing the money from the account at age 70.5.
For the 2017 tax year, the traditional IRA contribution limit is $5,500 per person. Thereafter, it is indexed for inflation in $500 increments. If you are age 50 or beyond, you may make “catch-up” contributions above the regular contribution limit to $6,500.
Say we’re talking about individuals and heads-of-household who have an employer-sponsored retirement plan. Then traditional IRA contributions are only tax-deductible if your modified adjusted gross income (AGI) is lower than $62,000 to $72,000.
The income phase-out range is $98,000 to $116,000 for married couples when the contributing partner has an employer pension plan. You can still contribute to a traditional IRA, but the trade-off is you can’t deduct the contribution from your income for relieving your tax burden.
Roth IRA
The Roth IRA was created by the Taxpayer Relief Act of 1997. You deposit funds on an after-tax basis. This means you have already paid taxes on the money you invest and there is no deduction for Roth IRA contributions.
However, the money in the account grows tax-free, and you can start withdrawing money without penalty upon reaching age 59.5. Generally Roth IRA distributions are not taxable; you already paid the tax on the income before you deposited it.
The primary advantage is that the interest or investment income your account earns is also tax-free. Roth IRAs have the same contribution limits as traditional IRAs. However, Roth IRAs do come with income limits, so not everyone qualifies for this type of account.
In 2017, individuals and heads-of-household with an AGI of $118,000 to $133,000 can contribute to a Roth IRA. For married couples filing jointly, this limit begins at $186,000 and goes up to $196,000. Since the income limits change annually, it’s good to check with your financial advisor and the IRS before investing.
SEP-IRA
A SEP-IRA stands for a Simplified Employee Pension Individual Retirement Account. The rules for this account are more complex than the rules for traditional IRAs or Roth IRAs. These accounts are often used by self-employed business owners who have few or no employees.
SEP-IRAs have the same general features as a traditional IRA. However, they come with much higher contribution limits. Like the traditional IRA, you cannot withdraw money without penalty before 59.5, and you must start taking out money from the account by the age of 70.5.
SIMPLE IRA
A SIMPLE IRA is another type of retirement plan. Many small business owners use this plan as well. SIMPLE is an acronym for Savings Incentive Match Plan for Employees. In this type of plan, employers may match at up to 3% of their employees’ contributions.
In 2017, the contribution limit is $12,500 per person. “Catch-up” contributions for people 50 and older is limited to $2,500. Small employers and self-employed individuals often use the SIMPLE IRA as an alternative to a 401(k) plan. Similar to traditional IRAs, deposits are tax-deductible. The business owner can act as both employer and employee. In other words, they can invest both the maximum contribution as well as the 3% employer match.
YOU CAN HAVE MORE THAN ONE IRA
You are permitted to have more than one IRA for enjoying tax benefits. It’s important, though to recognize that traditional and Roth IRA contribution limits are consolidated. This means you may contribute a total of $5,500 to any combination of traditional and Roth IRA accounts.
However, you can make contributions to a SEP or SIMPLE IRA in addition to your traditional or Roth IRA. It’s a good idea to seek financial advice so you can determine your contribution limits and discover the maximum amount of tax shelters for which you might qualify.
If you are ready, we invite you to request an appointment with our financial advisor of 30+ years, Greg Bernhardt. Request a meeting or call us at 925-287-8880 to get started.