Tuesday, July 5

IRA: what are the three different types and which one should I choose?

Although Roth and traditional IRAs are the de facto king and queen of the retirement account prom, there are a number of other appealing options that savers should consider.

There are other types of individual retirement accounts, though less well-known, provide the same tax-saving and money-growing benefits. Your IRA selection will be influenced by your income, employment status, workplace benefits, and other factors.

Here are the fundamentals different types of IRAs to help you determine which one will provide you with the most financial benefits.

Traditional IRA

According to data from the Investment Company Institute, the traditional IRA remains the most popular of the individual tax-advantaged retirement savings accounts. The following are some of the classic features:

  • In 2021 and 2022, you can get a $6,000 tax break up front, plus a $1,000 catch-up contribution if you’re 50 or older: Contributions may be tax deductible, lowering your annual taxable income. It all depends on your current income and whether you or your spouse participates in a company-sponsored retirement plan.
  • Investment earnings are tax-free as long as the money is kept in the account’s safekeeping.
  • Withdrawals made during retirement are taxed at your current tax rate.

A traditional IRA is best for people who are currently in a higher tax bracket than they expect to be in when they retire, as well as employees who do not have access to (or are not eligible to contribute to) a company-sponsored retirement plan.

Roth IRA

The Roth IRA is a tax-advantaged alternative to the traditional IRA. The following are some of its key characteristics:

  • While contributions are not tax deductible, which means there is no tax break up front, withdrawals in retirement are tax-free.
  • The maximum contribution per year is $6,000 ($7,000 if you’re 50 or older). Your income determines your eligibility to contribute to a Roth, but if you earn too much to contribute, there is a completely legal way to open one anyway via a backdoor Roth.
  • Roth IRA withdrawal rules are more lenient, allowing contributions to be withdrawn tax- and penalty-free at any time. With a few exceptions, taking money out before retirement incurs taxes and penalties.
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Those who expect to be in a higher tax bracket when they retire should take advantage of the tax-free withdrawals. If you think you’ll need to access some of your money before retirement, a Roth is a better option than a traditional IRA.

SEP IRA

Simplified employee pension is represented by the first three letters. Despite the fact that it’s a traditional IRA, it’s set up and funded for employees by an employer, who benefits from the effort. Earnings grow tax-free in a SEP IRA, while distributions in retirement are taxed. Other noteworthy features include:

  • The lesser of up to 25% of employee compensation or $58,000 in 2021 and $61,000 in 2022 are the annual contribution limits, which are much higher than those allowed in other tax-favored retirement accounts.
  • An employer is required to contribute equally to all employee accounts, including their own, on a percentage basis of salary.
  • The size of the contribution may vary from year to year depending on the cash flow of the company, but it must always be equal.
  • The size of the contribution may vary from year to year depending on the cash flow of the company, but it must always be equal for all eligible employees.
  • Employees are not permitted to contribute to the plan through salary deferral; they must have worked for the company for at least three of the previous five years; and they must have earned at least $600 in compensation during the year.
  • SEP IRAs are available to sole proprietors.
  • Workers over the age of 50 are not eligible for catch-up contributions.
  • Small-business owners who want to avoid the startup and operating costs of a traditional retirement plan, as well as the ability to increase their retirement savings and receive a tax deduction on any employee contributions.
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Just remember that if you’re both an employer and an employee, you must follow SEP IRA rules to avoid getting into trouble with the IRS.

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