One way to save for retirement is to open and fund an Individual Retirement Account (IRA). This savings account provides tax benefits on the money you’re saving for retirement. Knowing the differences between each IRA type can help you make the best choice for the income you need after you stop working.
A Traditional IRA is a pre-tax retirement account and your earnings grow tax-deferred. Depending on your situation, you may be able to contribute both pre- and after-tax dollars to your IRA. Contributions may be tax-deductible up to an annual income limit set by the IRS, if you meet certain requirements. You only pay taxes on your earnings and deductible contributions when you withdraw funds from the account. Because you don’t have to pay taxes on those funds as they grow, your balance can grow faster than the funds in a taxable account.
New this year is that you’re required to take minimum distributions beginning at age 72, up from age 70 1/2. This increased age limit gives your savings more time to grow. You can continue to contribute to the account as long as you have earned income.
A Roth IRA is funded with after-tax dollars and contributions are not tax-deductible. You pay taxes on the money now, but your earnings are tax-free when you withdraw funds later. Earnings are not taxed as long as the account has been open for five years and funds are not withdrawn before age 59 ½.
Keep in mind a Roth IRA has income restrictions, which may limit your eligibility to contribute. The Roth IRA income contribution limit for a single filer is $124,000 in 2020, while those married filing jointly cannot have income that exceeds $196,000.
A Simplified Employee Pension (SEP) is an IRA for self-employed individuals and small businesses, including nonprofit organizations and business owners who want to offer retirement benefits to their employees without the requirements of more complex plans.
Employers make tax-deductible contributions to an employee’s SEP IRA. Employees themselves do not make contributions. In most other ways, an SEP IRA account is like a Traditional IRA and follows the same investment, distribution and rollover rules as Traditional IRAs.
Am I eligible to contribute?
The IRS sets IRA investment rules on whether you are eligible to contribute to each IRA and if you can take advantage of the tax benefits offered by each. Your age, income, tax filing status and whether you or your spouse have a retirement plan at work, like a 401(k) or 403(b), all factor into the requirements.
The IRS restrictions around Roth IRA eligibility and Traditional IRA eligibility differ. How and when you can contribute funds to each type is also unique. Ask a financial professional for help deciding which option is best for you.
The advice provided is for informational purposes only. Contact a financial advisor for additional guidance.