Your Quick Guide To Types Of IRAs

An individual retirement arrangement (IRA) offers an opportunity to set aside savings for your future. While saving money for retirement through any account is a good idea, choosing the right retirement account can give your retirement savings more room to grow.

There are several different types of IRAs to choose from as you plan to save for retirement. These include:

1. Traditional IRA
2. Roth IRA
3. Nondeductible IRA
4. Spousal IRA
5. SEP IRA
6. Self-Directed IRA
7. SIMPLE IRA
8. Rollover IRA

What Is An IRA?

An IRA, or individual retirement account, is a tax-advantaged investment account designed to help you save for retirement. While your eligibility for different kinds of IRAs varies, the goal of each is to help you maximize your retirement saving strategy.

If you meet the eligibility requirements, you can contribute up to a maximum limit each year. As you make contributions each year, your retirement savings can grow. Unlike an employer-sponsored retirement account, such as a 401(k), you’ll have more control over an IRA. You’ll be able to set up an IRA through a brokerage platform.

What To Know About These 8 Different Types Of IRAs

Several kinds of IRAs exist. While the basic concept of an IRA is to make saving for retirement easier, the details of each account vary. For example, the contribution limits, withdrawals, distributions and eligibility vary across IRAs.

With a clear picture of each option, you can choose the IRA that best suits your needs.

1. Traditional IRA

When considering your IRA options, a traditional IRA is a tax-advantaged place to start your search. It’s a popular option, especially if you think you’ll be in a lower tax bracket in retirement.  As of 2023, you’re eligible to contribute up to $6,500 in 2023, or up to $7,500 if you are age 50 or older.

Traditional IRA contributions you make can be tax deductible, which lowers your overall taxable income. Within this account, your investment earnings aren’t taxed. However, you’ll pay income taxes on the investment earnings when you withdraw the funds in retirement.

Whether or not you have access to an employer-sponsored retirement plan, a traditional IRA gives you a pretax opportunity to save for retirement. If you need to make a withdrawal before age 59 and a half, you’ll pay an early withdrawal penalty.

During retirement, you’ll need to keep the required minimum distributions (RMDs) in mind. Starting at age 70.5, you’ll be required to take a minimum distribution from your IRA every year.

2. Roth IRA

A Roth IRA is another commonly used retirement account. Unlike a traditional IRA, a Roth IRA doesn’t come with any tax deductions. Instead, you’ll contribute post-tax funds and enjoy tax free withdrawals in retirement.

As of 2023, you can contribute up to $6,500 per year, or $7,500 if you’re age 50 or older. When you make contributions, you must wait 5 years before withdrawing the funds. Otherwise, you’ll face a penalty. Also, you’ll need to reach age 59.5 to avoid running into an early withdrawal penalty.

However, there are income limits to keep in mind. For example, married couples filing jointly can contribute up to the limit with a combined income of less than $218,000. But married couples filing jointly with a combined income of more than $228,000 cannot make any contributions to this type of IRA.

3. Nondeductible IRA

While some IRA contributions are tax deductible, a high income might prevent you from taking advantage of the tax deduction. If your household income exceeds the IRA income limits and you have access to an employer-sponsored retirement plan, then your IRA contributions may not be tax deductible.

Although you won’t be able to deduct your contributions from your taxable income, you’ll still access the benefit of tax-deferred growth on your investments. When you withdraw funds in retirement, you’ll pay taxes on any earnings. But you won’t have to pay taxes on your contributions, because you’ve contributed after-tax dollars. 

If you have a high income, tucking funds into a nondeductible IRA won’t come with an immediate tax break. However, the benefit of allowing your investments to grow tax-free until retirement is a worthwhile reason to pursue this option.

4. Spousal IRA

A key point of any kind of IRA is that you can only contribute earned income. So, if you earn $5,000 in a year, you won’t be able to contribute more than $5,000. The exception to this rule is for married couples.

If one spouse isn’t working, or has a lower income, each spouse can contribute up to the limit in their own IRAs. With that, one spouse can use earnings from their spouse to fund their IRA. The contribution limits are the same as a traditional or Roth IRA, which means both the working and non-working spouse can contribute up to $6,500 in separate IRAs.

Married couples must file a joint tax return and have an earned income in order to qualify for a spousal IRA. The IRS requires each spouse to open separate IRAs with their unique Social Security number.

Households with one non-working spouse can maximize their retirement savings options by opening a spousal IRA.

5. SEP IRA

A simplified employee pension IRA (SEP IRA), is available to small business owners. Through a SEP IRA, small business owners, including freelancers, can tap into the tax advantages offered by IRAs.

This is a type of traditional IRA, which means that you’ll be able to make pre-tax contributions. Throughout your savings timeline, your investments can grow tax-free. When you make a withdrawal, you’ll pay taxes on both the contributions and investment earnings.

As of 2023, you can contribute up to $66,000 or 25% of employee compensation, whichever is less. Business owners can make contributions both as the employee and the employer. From the employer side, you must make equal contributions, based on the salary percentage, to all employees.

Employees are allowed to contribute to the plan after working for the company for at least 3 of the last 5 years. If the employee earned at least $600, they can contribute to the SEP IRA. However, employees cannot contribute via a salary percentage. Instead, employees can contribute a dollar amount.

Business owners can tap into this opportunity for a tax deduction. For many self-employed individuals, your contributions vary from year to year. If you have a business with variable income, a SEP IRA might be the right fit. But if you’re getting a later start to saving, the lack of catch-up contribution opportunities might be a dealbreaker.

6. Self-Directed IRA

A self-directed IRA can be under the umbrella of a traditional or Roth IRA. With that, the contribution limits and income eligibility is the same as both the traditional and Roth IRAs. The difference is that a self-directed IRA gives you more control over the investments within your IRA.

IRAs through a regular brokerage platform usually come with access to mutual funds, stocks and bonds. But within a self-directed IRA, you can choose to invest in a wider range of assets, including precious metals and real estate.

Typically, you’ll need to work with a specialized custodian or trustee to handle the paperwork required by the IRA. Specialized custodians often offer access to a specific type of asset class. For example, you might find a custodian that offers self-directed IRAs with access to precious metals.

While there is more freedom associated with a self-directed IRA, the IRS puts many restrictions in place. For example, you cannot use this type of account to purchase life insurance or collectibles.

Many investors who opt for the self-directed IRA choose to purchase real estate. But it’s important to keep in mind that if you use the account to purchase real estate, you cannot make withdrawals to yourself for managing the property. For example, you will create a taxable event if you withdraw funds from the IRA to pay yourself for mowing the lawn.

A self-directed IRA is a useful choice for experienced investors seeking access to a wider range of investments. If you choose this option, take a close look at the rules to understand what the IRS allows and doesn’t allow through this type of account. Without a clear understanding of the rules, it’s easy to get tangled in red tape.

7. SIMPLE IRA

A Savings Incentive Match Plan for Employees IRA (SIMPLE IRA) offers an opportunity for employers and employees of small businesses to build retirement savings.

From the employer side, the business owner will generally need to contribute a 3% match. Alternatively, employers can make a fixed contribution of 2% of an employee’s salary. Regardless of the matching structure, the contribution limit is $15,500 in 2023. If you are 50 or older, you can contribute an extra $3,500.

As an employee, you cannot qualify for a SIMPLE IRA until you’ve earned at least $5,000 in the last two years from the company. A nice feature is that you may be able to roll the money into a traditional IRA after participating in the SIMPLE IRA plan for at least two years. Plus, some SIMPLE IRA plans allow you to choose which financial institution will hold your account.

When it’s time to withdraw funds, you’ll face a steep early withdrawal penalty of 25% if you pull the funds before age 59.5.

Both small business owners and self-employed individuals can find reasons to like SIMPLE IRAs. But the company must have fewer than 100 employees to qualify for this type of plan. If your employer is offering matching contributions through a SIMPLE IRA, you can jumpstart your retirement savings.

8. Rollover IRA

A rollover IRA happens when you roll funds from another type of retirement account into a rollover IRA. For example, it’s common to roll the funds from an employer-sponsored 401(k) into an IRA when you change jobs.

When you roll over the funds from a traditional 401(k) into a traditional IRA, you usually won’t encounter any penalties or taxes because the contributions were made pre-tax. It gets tricky if you want to roll funds from a traditional 401(k) into a Roth IRA, because the Roth is supposed to hold contributions from after-tax dollars. With that, you might run into a tax bill if rolling funds from a traditional 401(k) to a Roth IRA. 

At A Glance: Different Types Of IRAs

The details of an IRA can make a big difference in your retirement savings strategy. Below is a closer look at your options.

FAQs: Types Of IRAs

When it comes to planning your retirement, it’s good to get all your questions answered.

Which IRA is best for me?

The right type of IRA for you varies based on your unique financial situation and retirement goals. If you have extensive investment experience in a unique asset, a self-directed IRA might be the right choice. If your household has one non-working spouse, a spousal IRA could help you maximize your retirement savings. Consider consulting with a financial advisor to explore all of your options.

How many types of IRAs are there?

IRAs generally come in two varieties: traditional and Roth. But technically, there are eight different types of IRAs to choose from.

What is the difference between a Roth IRA and a traditional IRA?

The difference between a Roth IRA and a traditional IRA boils down to when you pay taxes. With a Roth IRA, you’ll contribute after-tax dollars. With a traditional IRA, you’ll contribute pretax dollars, which can lower your taxable income.

What are the different types of IRA distributions?

Required minimum distributions are a forced distribution required by the IRS. In contrast, you also have the option to make penalty-free withdrawals from your account when you reach age 59.5. Another option is to make an early withdrawal, which comes with a penalty.

The Bottom Line: There Are IRA Types For Different Retirement Savings Goals

Opening the right type of IRA can help you supercharge your retirement savings strategy.

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