Many have heard of an IRA but do they really know what it is or how the different types work? An IRA is an Individual Retirement Account. IRA’s are a way for you to save for retirement; something like a savings account but with limits on deposits, tax deferral, and restrictions & penalties on accessing the funds. Also, an IRA is an account and not an investment. The money is in the account and applied to different investments depending upon your choice of investment. Typical investments are stocks, bonds, mutual funds and/or other assets depending upon the type of IRA you opened.
Here is a breakdown of different IRA’s:
- Traditional IRA – Generally, you pay taxes on the money (what you put in) when you begin your withdrawals; the money you initially put in is therefore tax deferred. The thought process on this is when you begin your withdrawals (currently mandatory at age 70-1/2 but can start as early as age 59-1/2 penalty free) your income will be less so your tax bracket is lower therefore you will owe less in taxes than if you paid them as you earned the money. With the advent of the 401k many people that leave their employer with a 401k then move the money into a Traditional IRA account.
There are annual limits on how much money you can contribute to a Traditional IRA based upon your income and age. As an example, currently in 2016, if you are under age 50 you contribute $5,500 annually. If you currently contribute through an employer plan consult a tax advisor before contributing to your IRA as it many impact your tax deductions allowed.
You can request an early withdrawal from your account however it will be taxed and you will pay a penalty (currently 10%) if it is requested before age 59-1/2.
- Roth IRA – With a Roth IRA you pay the taxes on the money going into the account and then your future withdrawals, including earnings, are tax free. However, the account must be open for at least five (5) years and the distributions begin after age 59-1/2. There are allowances for penalty free withdrawals such as for a first time home buyer. Also, other withdrawals can be made tax-free; however, you might still have to pay a penalty. Always consult a tax advisor before making a withdrawal.
- SEP IRA – Generally just referred to as a SEP this is a Simplified Employee Pension IRA. The SEP IRA is used by business owners with one or more employee’s, those that are self-employed or have freelance income for a simplified method to save and contribute to the employee’s and their own retirement. A SEP IRA is opened for each individual and contributions are made to the IRA by the employer. The SEP IRA follows the same rules as a Traditional IRA.
- SIMPLE IRA – This is also for small business owners/employers and provides a simplified method for them to contribute to their and their employee’s retirement. SIMPLE stands for Savings Incentive Match Plan for Employees. This differs from the SEP IRA. Here employees may chose to make salary reduction contributions and the employer then makes matching or non-elective contributions. Each employee has their own SIMPLE IRA set up and contributions are made directly to that account.
- Self-Directed IRA – This is similar to the Traditional IRA. However, the big difference is that you have control of the investments. To open a Self-Directed IRA you must contact one of several companies out there that act as the custodian for your account. You work through the custodian on where you want the money invested. There are many more options for investing using this type of IRA. Some options are real estate, tax lien certificates, precious metals and so much more. However, there are strict rules on the self-directed IRA so be sure to do your research. For example: No loaning of money to yourself, your spouse or any family member in your direct linear family chain.
If you are interested in knowing more about IRA options you can check out information available on Roth Conversions and a Perpetual Pension that I have available for you. Also, there are two great videos from Frontline and 60 minutes for you to watch.