IRA stands for individual retirement account. IRAs are accounts that are given favorable tax treatment by the internal revenue service. They can be used in addition to 401(k)s or instead of 401(k)s for those who had not have a retirement plan at work. They are an important tool to help you boost your retirement savings, but there are different types of IRAs, and it is very important that you understand the differences, the rules, and the pros and cons of each so you can choose the right type for you.
What are the Different Kinds of IRAs?
The different types of IRA accounts include:
- A traditional IRA. A traditional IRA allows you to contribute $5,000 per year with pre-tax dollars. If you are over 50 years of age, then you can contribute $6,000. However, there are income limits and once your adjusted gross income reaches $59,000 (filing single) or $95,000 (filing jointly), then the amount you can invest tax-free begins to decline. Once you make $68,000 (filing single) or $112,000 (filing jointly), you can no longer contribute to an IRA with pre-tax dollars (i.e. you can no longer take the tax deduction for money invested).
- A Roth IRA. A Roth IRA allows for $5,000 in contributions each year for a someone under 50 and for $6,000 in contributions each year if you are over 50 although again there are income limits. A Roth IRA differs from a traditional IRA because you do not invest with pre-tax dollars (i.e. you do not take a tax deduction when you invest). Instead, the money grows tax free and you can take money out of the IRA without paying taxes on it. If you believe your taxes are going to go up when you are older, then you may wish to use a Roth IRA while you should use a traditional IRA if you think your taxes will go down. Traditional IRAs and certain other types of IRA accounts can be converted to Roth IRAs.
- A Simple IRA. A Simple IRA is essentially like a 401(k) plan for a small business. A Simple IRA is a qualified retirement account for a business with 100 employees or less. Simple IRAs are typically funded with deductions from the payroll of employees and employers may match contributions. There is a contribution limit of $11,500 with a $2,500 catch-up contribution permitted for those over the age of 50.
- Simplified Employee Pension or SEP IRAs. A SEP IRA is typically set up by an employer for an employee and is funded only by contributions from the employer and not through any payroll tax deductions. All contributions made to the SEP-IRA are tax deductible. SEP-IRAs can also be used by self employed business people who earn 1099 income. The contribution limits are much higher- it is possible to set aside $49,000 a year or up to 25 percent of an employee’s annual compensation.
- Spousal IRAs. Spousal IRAs allow for a working spouse to make contributions to an IRA account for a non-working spouse. The income of the working spouse is used to determine eligibility to contribute to a spousal IRA.
These are the most common types of IRAs that are used by individuals to invest for their future retirement. Each has many different advantages and different rules for withdrawal so it is important to research the types of accounts fully when making the choice about which is the right one for you.