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An individual retirement account (IRA) is a broad category of retirement savings plans. In fact, there are several different types of IRAs to consider. These include ones that individuals can open for themselves (like traditional and Roth IRAs), as well as ones that employers can set up for the benefit of their employees (like simplified employee pension (SEP) IRAs and savings incentive match plan (SIMPLE) IRAs).
Jump to one of these retirement savings plan types:
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Regardless of type, however, there are a few similarities that all IRAs share. For example, an IRA cannot be jointly held (remember – the “I” stands for “individual”). But that’s not to say that you can’t necessarily contribute to your spouse’s IRA if you have an income and your spouse doesn’t.
In addition, IRAs are often referred to as “tax-advantaged investment vehicles.” But it’s important to note that “tax-advantaged” can mean a couple of different things, depending on the type of IRA. Some allow tax deductible contributions (the money you put into your IRA on an annual basis). Others allow tax-free distributions (the money you get out of the IRA). Understanding these differences, and even the limits on these tax advantages, can help you decide which type of IRA might be the best fit for you.
If you received taxable compensation during the year, you may be eligble to make contributions to a traditional IRA. A traditional IRA is a retirement account in which individuals can typically make pre-tax contributions up to a specified maximum dollar amount (not including any catch-up contributions). You can begin to withdraw the funds, without incurring a 10% early withdrawal fee, when you turn 59 ½, and you must begin taking distributions from your IRA when you turn 70 ½.
Three advantages to remember:
Like a traditional IRA, a Roth IRA also provides tax-free growth on investments. However, unlike a traditional IRA, you can only contribute to a Roth IRA with after-tax dollars. In addition, your contribution amount might be limited based on your filing status and/or income.
But, because you’ve paid taxes on your contribution to the IRA up-front, generally you don’t pay taxes on the payouts you receive from your Roth IRA.
A simplified employee pension (SEP) plan is a kind of IRA that allows business owners to make tax-deductible contributions for their own and their employees’ retirement. If you have an SEP IRA through your employer, you own and control the plan, but only the employer contributes to it. As such, you don’t pay taxes on the contributions that your employer makes. But, you will pay taxes on the distributions you receive from the account, plus any earnings made.
A savings incentive match plan for employees (SIMPLE) IRA is a retirement plan that small employers (think: fewer than 100 employees), including self-employed individuals, can set up. SIMPLE IRAs allow employees to contribute pre-tax dollars to the plan while requiring the employer to make either matching contributions (up to 3% of compensation) or nonelective contributions.
The difference between the two is simple: Matching contributions are based on what the employee puts in, while nonelective contributions are consistently paid to employees regardless of whether or not they contributed anything.
You can – and should – name a beneficiary of your IRA. Here are some things to consider ahead of time:
This can be very straightforward. Your spouse can take control of the assets as his or her own and follow the regular rules for making IRA withdrawals. But if your spouse is younger than 59 ½ years old, the age at which IRA early-withdrawal penalties subside, he or she may want to leave the inherited IRA intact and use the rules other beneficiaries must follow.
Withdrawal rules get more complicated in this case, but the basic thing to remember is that withdrawals are required every year.
Think of an inherited IRA as a frozen account. As such, it can't be rolled over into another IRA and no additional contributions can be made. In addition, no matter how old the beneficiary is, he or she must make a withdrawal every year.
There is, however, one noteable exception: If the IRA was inherited before the original owner reached age 70 ½, the beneficiary can choose to withdraw all the money within five years. However, the beneficiary would still owe any income tax due on the withdrawal.
Otherwise, the beneficiary can choose to stretch out the payouts by taking smaller annual distributions, called required minimum distributions (RMDs). The dollar amount of these RMDs are based on the beneficiary’s own life expectancy.
In addition to the control-factor, a trusteed IRA may offer a cost-advantage over establishing and maintaining a traditional trust and is also protected from creditors.