An Individual Retirement Account or IRA is a tax-exempt or tax-deferred way to save for retirement. There are many different types of plans to choose from and each has its own advantages depending on your situation.
It’s important to choose the one that’s right for your needs since there’s no “one size fits all” solution to retirement. You may not even qualify for all the plans available since there are income limitations and special provisions on some of these.
Listed below are some of the most common types of Individual Retirement Accounts used today.
Traditional Individual Retirement Account
With a Traditional IRA the money you contribute is tax deductible. This means that all contributions made to the plan reduce your taxable income therefore reducing the amount of taxes you owe.
Although this is a great perk it may not apply if you or your spouse are covered by an employer’s retirement plan. Depending on your situation, you may only be allowed to deduct a portion of the contribution or none at all.
If this is an issue, you can always opt for a Nondeductible Traditional Individual Retirement Account. It’s identical except for the tax treatment of the original contribution.
However, regardless of your circumstances you won’t be taxed on interest, dividends or capital gains you receive so it grows tax deferred.
When you begin withdrawing funds from the account at retirement, the amount withdrawn is taxed at that time just like regular income.
However, anything withdrawn before age 59 ½ will be taxed as income and hit with a 10% penalty as well. Although this seems steep it’s a pretty fair trade-off for all the tax advantages offered.
There is an exception however. If the money is withdrawn to purchase a home or for approved higher education costs the 10% penalty is waived. But you will still have to pay income tax on that amount. If given the choice however, get a mortgage or student loan and leave your retirement account intact.
Roth Individual Retirement Account
The Roth IRA is very popular due to the fact that it's somewhat more flexible in a few important areas. Namely, the contributions can usually be withdrawn without taxes or penalties after five years.
Also there is no required distribution based on age. Most other Individual Retirement Accounts require you to begin withdrawing funds by age 70 ½. Not so with a Roth IRA. You can choose to let the funds grow tax free indefinitely and pass it on to your heirs if you’d like.
They differ in other ways as well. Contributions are not tax deductible. The upside is the distributions are completely tax free as long as you meet the requirements. You basically pay the taxes upfront and reap the rewards at the end with these plans.
Your money also grows tax free since you’re not required to pay taxes on growth and earnings.
There are however earning caps that prevent higher income earning individuals and couples from participating in the Roth IRA. These plans are designed for the middle-class and are a great way to grow your nest egg.
Simplified Employee Pension Individual Retirement Account
SEP Individual Retirement Accounts are similar in most respects to the Traditional. The contributions are tax deductible, they grow tax free and distributions are taxed as regular income. They also have penalties for early withdrawals.
However, the SEP is a group retirement plan set by an employer. The employer makes periodic contributions to the plan on your behalf. The amount is usually a percentage of your pre-tax income.
These plans usually allow higher contribution limits than traditional plans making them a popular choice for growing your net worth more quickly.
Savings Incentive Match Plans for Employees
SIMPLE IRAs are a group plan as well. They are similar to other retirement plans including the 401k in that the contributions are from pre-tax dollars, there is a penalty for early withdrawal and distributions are taxed as income.
There are lower contribution limits than with most other plans but fees tend to be lower as well making them attractive in some cases.
Regardless of which type works best for you, it’s important start saving for retirement as soon as possible. The longer you save the better off you’ll be in the future. And while all IRAs have certain limitations and restrictions, overall they're a great way to save for retirement.From IRA to Investing Money