8 IRA Types That Could Amplify Your Retirement Plan

This guide to the eight different types of IRAs can help you minimize your taxes and maximize your retirement savings.
Last updated Oct 2, 2020 | By Lee Huffman
8 IRA Types That Could Amplify Your Retirement Plan

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Individual Retirement Accounts are a valuable tool to grow your money while saving for retirement. Many people are familiar with traditional and Roth IRAs, but you might not realize there are more IRAs beyond those two options. In fact, if you don’t know about these other accounts, you could be missing out on some tax-saving opportunities.

This in-depth guide will discuss the benefits of eight IRA types that could help you maximize your tax benefits, understand how to invest money, and successfully save for retirement — all at the same time.

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Why it’s important to know your IRA types

Knowing what IRA choices are available to you will help you determine which account is right based on your income and personal finance goals. Depending on your situation, you may even be able to open and contribute to multiple IRA accounts at once.

When used correctly, IRA contributions can increase your tax efficiency (reduce your tax burden) and as such, they can be an important part of your tax planning. So let’s look at the different types of IRAs that are available, and whom they might be the best fit for.

1. Traditional IRA

  • Who it’s best for: People who expect to be in a lower tax bracket in retirement and those who don’t have an employer-sponsored plan
  • Contribution limit: $6,000 ($7,000 if you're 50 years or older) for 2020
  • Taxes: Contributions are tax-deductible in the year they are made. Money is taxed as ordinary income at the time of withdrawal

Who it's best for

Traditional IRAs are retirement accounts that provide a tax deduction in the year you contribute. Basically, they reduce your amount of taxable income. Traditional IRAs are best suited for investors who are in a higher tax bracket today than they expect to be in retirement. Additionally, taxpayers who are close to being eligible for tax breaks can use traditional IRA contributions to reduce their taxable income to become eligible for those incentives.

People in a high tax bracket without an employer-sponsored retirement plan stand to benefit the most by making traditional IRA contributions. The highest federal income tax bracket is 37%. This means that someone filing individually will pay 37 cents in taxes on every dollar of taxable income above $518,400. If that same individual contributed $6,000 to a traditional IRA, they could save up to $2,220 in taxes ($6,000 x 37% = $2,220). By comparison, someone in the lowest tax bracket of 12%, would save only $720 ($6,000 x 12% = $720). That's a $1,500 difference.

In addition, contributing to a traditional IRA may also make you eligible for other tax breaks by reducing your income below certain hurdles. These income-based tax breaks include:

  • Student loan interest deduction
  • Tuition and fees deduction for spouse and dependents
  • American Opportunity Tax credit
  • Child tax credits
  • Adoption credits

Contribution limit

For the tax year 2020, you may contribute up to $6,000. People who are 50 years or older may perform catch-up contributions of up to an additional $1,000, for a total of $7,000.

If your employer offers a company retirement plan, your ability to deduct your traditional IRA contribution may be affected by your Modified Adjusted Gross Income. You may still contribute to the annual limits, but your ability to deduct your contribution may be affected. We'll discuss non-deductible IRAs later in this article.

Filing status You can take the full deduction if you make... You can take a partial deduction if you make... No deduction is available if you make...
Single or Head of Household $65,000 or less $65,001 to $74,999 $75,000 or more
Married Filing Jointly $104,000 or less $104,001 to $123,999 $124,000 or more
Married Filing Separately N/A Less than $10,000 $10,000 or more

How a traditional IRA is taxed

Qualifying contributions to a traditional IRA are tax-deductible in the year they are made. The investments continue to grow tax-deferred, which means you do not owe taxes on the earnings until you make a withdrawal. When you make withdrawals, the amount is taxed as ordinary income. Withdrawals made before you turn 59 1/2 may be also subject to taxes and penalties.

In the year you turn 72, traditional IRAs become subject to required minimum distributions. The amount of the RMD is calculated based on your age, the balance in your account, and the life expectancy factor published by the IRS. If you fail to withdraw your RMD each year, the amount that is not withdrawn will be taxed at a rate of 50%.

2. Roth IRA

  • Who it’s best for: Young investors and those who expect higher taxes in retirement
  • Contribution limit: $6,000 ($7,000 if you're 50 years or older) for 2020
  • Taxes: You don’t get a tax deduction when you contribute, but all withdrawals are tax-free in retirement

Who it's best for

Roth IRAs are best for people who have many years to go before reaching retirement age. This account allows for your contributions to grow tax-deferred into a large sum of money that can be withdrawn tax-free in retirement.

Additionally, if you expect that income tax rates will increase over time, a Roth IRA could be a better fit for you. You'll forgo the tax deduction at today's income tax rates in exchange for being able to withdraw money tax-free in the future.

Contribution limit

Roth IRAs have the same $6,000 annual contribution limit ($7,000 for 50 years and above) for 2020 as a traditional IRA. However, there are different income limitations:

Filing status You can take the full deduction if you make... You can take a partial deduction if you make... No deduction is available if you make...
Single or Head of Household Less than $124,000 $124,000 to $138,999 $139,000 or more
Married Filing Jointly Less than $196,000 $196,000 to $205,999 $206,000 or more
Married Filing Separately N/A Less than $10,000 $10,000 or more

How a Roth IRA is taxed

You will pay taxes on the money you contribute to your Roth IRA, but the earnings on those contributions grow tax-free. You may withdraw Roth IRA contributions at any time. If you plan on achieving early retirement, these contributions could be withdrawn to subsidize your income until you reach a more traditional retirement age. But this only applies to the amount you contributed to your Roth IRA. If you withdraw the earnings on your Roth IRA before reaching age 59 1/2, that money may be subject to taxes and penalties.

3. SEP IRA

  • Who it’s best for: Self-employed people and business owners with limited employees
  • Contribution limit: The lesser of 25% of compensation or $57,000 for 2020
  • Taxes: Deductions are tax-deductible and withdrawals are taxed as ordinary income

Who's it best for

A SEP IRA (Simplified Employee Pension IRA) is a low-cost self-employed retirement plan for entrepreneurs and business owners. Because the IRS requires that business owners contribute the same percentage of salary for every employee, a SEP IRA is best suited for solopreneurs or small business owners with a limited number of employees. Otherwise, the tax benefits for large contributions to your own account will be offset by the contributions you’ll be required to make to employee accounts.

Contribution limit

IRS rules limit your contributions to the lesser of 25% of compensation or $57,000. Compensation up to $285,000 may be considered in the calculation of the maximum contribution. Companies are not required to contribute to SEP IRA accounts each year and the contribution amount can vary from year to year.

Self-employed people must use a special calculation to determine their maximum contribution. This calculation can be complicated and involves your net income, the deductible portion of self-employment tax, and your personal contributions. To ensure the calculation is done correctly, it’s best to speak with a tax professional.

How a SEP IRA is taxed

SEP IRA contributions are tax-deductible for the business. Withdrawals by employees are considered taxable income in retirement. If you withdraw prior to 59 1/2, you may be subject to taxes and penalties. These IRA types are also subject to RMDs beginning the year you turn age 72.

4. Spousal IRA

  • Who it’s best for: Non-working spouses who want to save for retirement
  • Contribution limit: $6,000 ($7,000 if you're 50 years or older) for 2020
  • Taxes: Vary depending upon the IRA type chosen

Who it's best for

Spousal IRAs allow non-working spouses to contribute to their retirement each year. Spousal IRAs are best for married couples who file their taxes jointly. This strategy is ideal when one spouse does not work or does not make enough on their own to fully fund an IRA.

Keep in mind that there is not an actual spousal IRA account. Rather, this is an IRS policy that allows spouses to contribute to an IRA based on the couple's combined income.

Contribution limit

You are limited to a maximum contribution of $6,000 per year ($7,000 if over 50 years old) for 2020. Your ability to contribute may be limited based on your combined household income, filing status, and the IRA type you select (traditional or Roth). See the appropriate section above for specific guidance.

How a spousal IRA is taxed

The IRA type that you select for the spousal IRA strategy will dictate the taxation of your contributions and withdrawals. The sections above regarding traditional and Roth IRAs will help you decide which type of IRA is best for you.

5. SIMPLE IRA

  • Who it’s best for: Businesses with fewer than 100 employees
  • Contribution limit: Company is required to contribute a percentage of salary each year
  • Taxes: Companies deduct contributions; withdrawals are taxable for the employee

Who it's best for

A SIMPLE IRA allows employers to contribute to traditional IRAs set up for their employees. The acronym stands for Savings Incentive Match Plan for Employees.

SIMPLE IRAs are available for all small businesses, but they are best for companies with fewer than 100 employees. These plans are simple to administer because there are no filing requirements. Plus, they do not have the startup and operating costs of more popular company retirement plans like a 401(k).

Contribution limit

With a SIMPLE IRA, both the business and employees may contribute. The employer is required to contribute either:

  • A matching contribution up to 3% of the employee's compensation
  • A 2% non-elective contribution on up to $285,000 in salary per person for eligible employees who don't invest in their accounts

An employee may contribute up to $13,500 to their SIMPLE IRA for 2020. If the employee is 50 or older, they may make catch-up contributions up to $3,000 in addition.

An upside to the SIMPLE IRA for employees is that they are immediately 100% vested in the value. This means they could transfer or withdraw the entire balance when they leave the company.

How a SIMPLE IRA is taxed

The business can deduct its contributions to the SIMPLE IRA accounts. Employee accounts will continue to grow tax-deferred until withdrawals are made. Money withdrawn is taxed as ordinary income. Employees must take RMDs beginning in the year they turn 72. If you withdraw money before age 59 1/2, you may owe taxes and penalties on the amounts withdrawn.

6. Self-directed IRA

  • Who it’s best for: Investors who prefer alternative investments
  • Contribution limit: Vary depending upon the IRA type chosen
  • Taxes: Vary depending upon the IRA type chosen

Who it's best for

A self-directed IRA is a strategy in which the owner can invest in alternative investments. Some real estate investors used self-directed IRAs to purchase rental properties. With a self-directed IRA, you can buy individual properties or invest through real estate platforms like Crowdstreet or Fundrise.

Self-directed IRAs are best for investors who are organized and have the proper third-party custodians in place. There are a lot of rules to follow with self-directed IRAs to ensure you're not commingling your retirement account funds with your taxable money (e.g. brokerage or bank accounts). The IRS has a list of prohibited transactions you need to be aware of before choosing this strategy.

Contribution limit

You can convert any amount of the funds available in your existing IRA types into a self-directed IRA. Additionally, your annual contributions can also be made to your self-directed IRA. However, be aware that if your self-directed IRA investments require additional money, you may not exceed your annual contribution limits. For that reason, it is always best to have additional capital available in your IRAs.

How a self-directed IRA is taxed

Tax impacts vary based on the IRA types that you are converting to a self-directed IRA. Additionally, if the IRS determines that you've engaged in a prohibited act, your account will then be treated as if it was fully distributed using its value as of January 1 of that year. This could cause you to pay taxes and penalties on the full balance of your retirement account.

7. Non-deductible IRA

  • Who it’s best for: People who make too much money to deduct IRA contributions
  • Contribution limit: $6,000 ($7,000 if you're 50 years or older) for 2020
  • Taxes: Non-deductible, but grow tax-deferred

Who it's best for

Non-deductible IRAs offer tax-deferred growth for investors who cannot deduct traditional IRA contributions. Non-deductible IRAs are best for people who want to contribute to an IRA but make too much money. For the tax year 2020, deductions for traditional IRAs start phasing out at an income of $65,000 for a single person who has a company retirement plan available to them. The ability to contribute to a Roth IRA starts being phased out at $124,000.

Contribution limit

The contribution limit is the same as a traditional IRA. You can contribute up to $6,000 per year, with an extra $1,000 per year if you're aged 50 or older for the tax year 2020.

How a non-deductible IRA is taxed

In a non-deductible IRA, your money grows tax-deferred. When you begin making withdrawals, the ratio of contributions to earnings will determine your taxable income. For example, if you make $60,000 in non-deductible contributions and the account grows to $100,000, then $40,000 are considered earnings. That means 40% of each withdrawal is taxable.

Some savvy investors choose to convert their non-deductible IRAs into Roth IRAs. They pay the taxes on any earnings the account has made at the time of conversion in exchange for tax-free withdrawals in the future. Depending upon how long you have before retirement and your personal financial situation, these tax savings can be huge.

8. Rollover IRA

  • Who it’s best for: An employee who leaves their company
  • Contribution limit: There is no limit to how much you can rollover from your company retirement plan
  • Taxes: Rollovers are considered non-taxable events as long as rules are followed

Who it's best for

A rollover IRA is a personal retirement account that holds the investments that were transferred from an employer retirement account. For example, you might roll over a 401(k) to an IRA.

A rollover IRA is best for people who have left their job and want to relocate their company retirement money. This could be you if you’re wondering what to do with a 401(k) after leaving a job. By transferring the money into an IRA, you'll have greater control over the type of investments you choose and it will no longer be subject to the rules of your former company's retirement plan.

Contribution limit

There are no limits to the amount of money you can roll over from a company retirement account to a personal IRA. Because a rollover IRA is really just a traditional or Roth IRA with funds from your company retirement plan, it is possible to also make annual IRA contributions to this account. Just be aware that making a contribution to this account may cause you to lose the ability to roll it back into a future employer's retirement plan.

How a rollover IRA is taxed

When you transfer investments from a company retirement plan to an IRA, there are no taxes due as long as you follow certain rules. If your former employer issues a check to you instead of your new IRA administrator, you will have 60 days to complete the transfer. The full amount must be deposited into your new account by the deadline, even if your former employer withholds taxes. Whatever amount is not deposited may be subject to taxes and penalties.

The best option is to initiate a direct transfer in which the money is sent from your former employer to your rollover IRA. This eliminates the possibility of missed deadlines and penalties.

Bottom line

IRAs can be a powerful tool in your retirement savings plan. There are many IRA types to consider and some people may have multiple types of IRAs open at one time. Knowing how each IRA works gives you the knowledge to maximize the tax-savings opportunities available to you.

If you feel overwhelmed by so many IRA types, you should speak with a tax professional or financial advisor. They can look over your situation and help you decide what your options are and which IRAs could work best for you.

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