An individual retirement account (IRA) is a specific type of savings and investment account that can be used by most individuals to save for retirement while enjoying certain tax advantages.
The specific tax rules are different between different types of IRAs, but the benefits that these retirement accounts offer make them a prudent inclusion in most individuals’ retirement planning. Particularly, if you invest early, the tax advantages coupled with compounding can put you in a safe place when it becomes time to stop working.
Comparing Types of IRAs
There is a variety of IRA types, with the differences being driven by when and how money is contributed to the retirement account. IRAs can hold CDs, stocks, bonds and other investment types, although limitations beyond those imposed by the law may be determined by a given financial institution. Real estate, for example, is often excluded by big financial institutions.
Here are some of the different types of IRAs you can use to start saving for retirement:
1. Roth IRA
Roth IRAs are similar to traditional IRAs in the fact that they have special tax rules. But there are several important differences.
With a Roth IRA, your contributions are not tax deductible, meaning you are depositing after-tax dollars into the account. While funds are in the account, they grow tax-free, and there is no tax due when the money is withdrawn upon retirement.
Additionally, you are allowed to leave some money in a Roth IRA for as long as you are alive, unlike with a traditional IRA that requires regular withdrawals. A $5,500 limit applies to contribution to a Roth IRA, with the added requirement that your adjusted gross income (AGI) be below certain thresholds — $116,000 to make the full contribution as a single tax filer.
2. Traditional IRA
With a traditional IRA, you are allowed to contribute a certain amount each year to the account in pre-tax dollars. This means that your contribution is fully or partially tax deductible up to the maximum allowable limit. The maximum annual contribution for 2014 and 2015 is capped at $5,500, although it is higher for older individuals ($6,500).
Once money is in your IRA, you will not have to pay any taxes on your earnings in this account until that money is withdrawn. The advantage of this tax deferral is that by the time these individuals are ready to withdraw funds after retirement, they will be in a lower tax bracket than when the money is earned.
3. Rollover IRA
While many IRAs fall into one of the above two retirement accounts, there are a few special circumstances that can create other types of IRAs. A common type is known as a rollover IRA.
A rollover occurs when you are transferring funds from a previous retirement account into another IRA or retirement plan. Under IRS rules, you have 60 days to deposit the money into another qualifying account to avoid any tax consequences.
Starting in 2015, the IRS is imposing a limit of one rollover in any 12-month period. The exceptions to this rule include transfers from one trustee to another and the conversion of a traditional IRA into a Roth IRA. Under these exceptions, there are no limits.
4. SEP, SARSEP and Other Types of IRAs
There are three types of IRAs that are not considered payroll deduction accounts. With either a Roth or a traditional IRA, the individual will often allocate a portion of his or her paycheck to be directly deposited into the retirement account. Under these three account types, this is not always necessarily the case:
- SEP: Under a Simplified Employee Pension (SEP) plan, an employer is able to make direct contributions to employees’ retirement accounts (SEP-IRA) and their own retirement plans.
- SARSEP: The Salary Reduction Simplified Employee Pension (SARSEP) is an SEP plan set up before 1997 that has features of both an SEP plan and a payroll reduction plan. The benefit is that these plans tended to have lower costs.
- SIMPLE IRA: A Savings Incentive Match Plan for Employees (SIMPLE) is a plan in which an employer contributes to their employees’ retirements and their own. Employees may also deduct from their salaries, and the employers can match the contributions.
While these three plans are less common in today’s workforce, they are still available in some cases.
Keep reading: What to Do When Your Job Offers an Awful Retirement Plan
How to Choose an IRA
While there are no set criteria on what defines the best IRA, there are some common practices that can help you ensure that your needs are met. This often starts with understanding those needs, both in terms of your savings and retirement goals, but also in terms of your risk tolerance.
Understand IRA Terms and Requirements
The rules that govern IRAs are formulated and disseminated by the IRS. These rules, however, are just a part of the process, as specific banks and financial institutions might add additional rules. In some cases, different investment types and ancillary services might be offered, as well as advice from the given institution.
One of the most important rules to be aware of is the required minimum distribution. Once you have reached a certain age, you are required to take a certain portion of your money out of your retirement account. Understanding these amounts and how they fit into your overall financial plan can be a critical step. So when you select a institution, you might wish to pick one that can handle your other needs as well.
Evaluate IRA Risks and Rewards
The biggest decision involved in opening an IRA is deciding what investment instruments to put your money into. While options like CDs tend to provide a very safe yield, the return can be quite low, especially under a low interest rate environment. Options like mutual funds, stocks and bonds tend to provide more return potential, but they also carry additional risks.
Balancing these various concerns within your overall framework involves making an asset allocation plan based on your specific needs. Doing this will help you define what is important to you within the context of your retirement goals and comfort level. Once this step has been completed, you will be in a better position to evaluate the options that are available.
Be Aware of IRA Fees
According to a survey by Rebalance IRA, 46 percent of full-time employed baby boomers believed that they do not pay fees at all, reports Fox Business. The survey results demonstrate that many people don’t fully realize the fees associated with their retirement accounts.
Fees can play a central role in the returns you are able to generate in your IRA, and understanding them is important. While paying an advisory fee could be justifiable if you are given expert guidance and investment management help, this should be weighed against the actual value of that help. If you are buying commission-bearing products, an advisory fee simply ups the cost.
“In the case of an IRA and Roth, the fee structure will depend on whether the plan holds a mutual fund directly, buys mutual funds brokers or is large enough to be managed as a customized portfolio of individual stocks and bonds,” Chris Carosa, a financial advisor and author of “Hey! What’s My Number? How To Improve The Odds You Will Retire In Comfort,” told Fox Business.
When comparing accounts and products, do not forget to evaluate the relative fees so that you are making a fair comparison.
Keep reading: 31 Things to Know About Investing Your Money
How to Open an IRA
The breadth of options available when opening an IRA can be overwhelming, as institutions such as banks, credit unions, brokerage firms and mutual fund companies offer these retirement accounts. If you already have a relationship with a financial institution, this might be the best place to start, especially if you built up a good level of trust. Making sure that the choice you make is equipped to meet your needs, however, should be your primary focus.
The underlying message: Choosing an IRA can be a daunting task, but the choice you make is critical. Once you have defined your needs, the institution you select should help you complete the necessary paperwork and offer personal assistance to help you get started.