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Retirement planning is a major financial goal for most people, regardless of their age. Your strategy might vary depending on the point in your life where you’re at and at what age you want to retire, but for the vast majority of people, their plan includes an IRA.
You might be exploring IRAs and what type is right for you. Maybe you got a recent cash windfall from selling a car or an inheritance, for example, and you want to set it aside. You might just be at a point in your life and your career where you feel like you’re ready to think more seriously about a long-term financial plan.
With that in mind, the following are things to know about IRAs generally and the different types available—or at least the most popular types.
What is an IRA?
IRA stands for an individual retirement account.
These are tax-advantaged investment accounts to help you save for your retirement. There are four main types of IRAs, all of which have tax benefits that are meant to reward or incentivize savings.
You can open one of these accounts at a bank or through a broker or robo-advisor. When you invest in these accounts, your money grows and compounds. You can invest in assets including stocks and bonds. How your account grows depends on your contributions and your investment accounts.
There are contribution limits and withdrawal rules. For example, if you withdraw your money before you’re 59 ½, you may face a tax bill and a 10% penalty unless you qualify for an applicable exception.
When you max out the contribution to your IRA, you’re not only saving for retirement and reducing your tax bill, but it gives you flexibility beyond what your employer could provide.
Traditional IRA
A traditional IRA features contributions that are typically tax-deductible. If you contribute $6,000 to your traditional IRA, you can usually reduce your taxable income by the same amount. If you withdraw money from a traditional IRA, that’s taxable like your ordinary income.
For 2021 and 2022, the contribution limit for traditional IRAs is $6,000 annually. If you’re 50 and older, you can contribute a maximum of $7,000 annually. If you’re married and either you or your spouse has a retirement plan through your job, the amount of the traditional IRA you can deduct is either reduced or eliminated if you have a certain income.
You can still make contributions—they just aren’t tax-deductible.
Roth IRA
Another commonly used type of IRA is the Roth. Roth IRA contributions are different from a traditional IRA because they aren’t tax-deductible. On the other hand, withdrawals are tax-free, and there aren’t taxes on investment gains.
If you have a long time before you’re going to be retiring, a Roth IRA may work well for your needs. Basically, you have to ask yourself if you want to pay taxes now or later if you’re deciding between a traditional and Roth IRA.
For 2021 and 2022, max contribution limits are again $6,000 a year and $7,000 if you’re 50 or older. This is if you have a modified gross income below $140,000 as a single filer. If you’re married filing jointly, it’s $208,000 for 2021 and $214,000 in 2022.
SEP IRA
A Simplified Employee Pension (SEP) IRA is something employers can create for their employees and to benefit themselves. If you’re self-employed, you can also set up a SEP IRA.
Employers can make tax-deductible contributions to their employees who are eligible to their SEP-IRA account.
They’re easy to set up, with low administrative costs. If an employer creates these, they can decide how much to contribute annually.
There are higher contribution limits, and a SEP IRA is just a traditional IRA, but employer contributions can be made.
You have to earn at least $650 from an employer to qualify. You have to be at least 21 years old, and you must have worked for the employer in three of the past five years.
In 2021, contributions can’t be more than the lesser of 25% of an employer’s compensation for the year, or $58,000. For 2022, it’s $61,000.
Simple IRA
Simple stands for “Savings Incentive Match Plan for Employees.”
The Simple IRA is intended to be like a 401(k) plan for smaller companies. Many of the rules that apply to IRAs, in general, will apply to a Simple IRA. Eligible employees can contribute part of their pre-tax salary to an individual account. They receive mandatory employer contributions.
Simple IRAs are for businesses with fewer than 100 employees. They’re easier to set up than a 401(k) and have lower employee contribution limits.
IRA vs. 401(k)
The different types of IRAs are similar to 401(k)s in some ways but also have differences.
Both IRAs and 401(k)s grow tax-free, so you don’t have to pay taxes on the interest and earnings, but you do on distributions and withdrawals.
A 401(k) is offered by employers to their employees. Employees contribute funds to their accounts through salary deferrals. A salary deferral means a percentage of the employee’s salary is withheld and then contributed to their 401(k).
The money is usually put into different investments, like a collection of mutual funds, which the account’s sponsor chooses. The choices are supposed to adhere to a certain level of risk tolerance, so employees can take on what they’re comfortable with. The income accrues and compounds on a tax-free basis.
Contributions to a 401(k) are pretax, so the total of the contributions reduce your taxable income that year by that amount.
In 2021, a participant is able to contribute up to $19,500 a year. That’s going up to $20,500 in 2022. There’s what’s called a catch-up contribution of $6,500 that people 50 and older can make.
Finally, an employer will often match a percentage of your 401(k) contribution up to a percentage or limit.
Employers frequently base their matching on how much they contribute.
