Last Updated:

Types of Individual Retirement Accounts (IRA)

Planning for retirement is essential since it helps you organize your finances through retirement investments. As such, you need to have a strategy for your retirement. There are many investment approaches you can take to save for your retirement. In this article, we will take you through the different types of Individual Retirement Accounts that can help you gain access to a wider range of investment options.

What is an Individual Retirement Account?

An Individual Retirement Account (IRA) is a tax free account that helps you save for your retirement. An IRA is similar to a 401(k). You can manage the account yourself instead of your employer managing it for you.

An IRA is a long term retirement savings account and withdrawing money before the age of 59.5 attracts a penalty of 10%. However, there are some exceptions; you can withdraw money from an IRA for educational purposes, first-time home purchases, disabilities, medical expenses, or other unusual life events penalty free.

Types of Individual Retirement Accounts

There are several types of IRAs, each with different rules regarding eligibility, withdrawals, and taxation. They include traditional IRAs, Roth IRAs, Savings Incentive Match Plan for Employees (SIMPLE) IRAs, and Simplified Employee Pension (SEP) IRAs.

1. Traditional Individual Retirement Account

Traditional IRA allows you to contribute pre-tax dollars to a retirement account. IRA earnings are tax free until you retire. Thereafter, your IRA withdrawals are taxed at the ordinary income tax rate. That way, your money grows on a tax-deferred basis in a traditional IRA. If you contribute say $4, 000 into an IRA, your taxable income for the year decreases by that amount.

2. Roth Individual Retirement Account

Roth IRA is a special IRA where your contributions are taxed, but qualified distributions are tax free. You contribute to a Roth IRA using after-tax dollars, but you do not have to pay taxes on investment gains. Upon retirement, you can withdraw from the account without incurring any income taxes on your withdrawals.

Roth IRAs also do not have required minimum distributions (RMDs). If you do not need the money, you don’t have to withdraw it from your account. There are income limitations to open a Roth IRA. The current contribution limits are $6, 000 if you are under age 50 and $7,000 if you are age 50 or older.

3. Savings Incentive Match Plan for Employees (SIMPLE) IRA

SIMPLE IRA is a kind of an IRA that allows employees and employers to contribute to traditional IRAs set up for employees. It is available to small businesses that do not have any other retirement savings plan. It is similar to a 401(k) plan but with simpler and lower contribution limits. SIMPLE IRA follows the same tax rules for withdrawals as a traditional IRA.

4. Simplified Employee Pension (SEP) IRA

SEP IRA contributions allows employers (small businesses and self-employed individuals) to make retirement plan contributions into a traditional IRA that is established in the employee’s name. However, the employees cannot contribute to their accounts. The IRS taxes the withdrawals just like normal income.

5. Inherited IRA

An Inherited IRA is an account that is opened when someone inherits an IRA or employee-sponsored retirement plan after the death of its initial owner. Tax-deductible contributions or IRA conversions aren’t allowed. However, the funds can remain tax-deferred, and you can withdraw money right away without a penalty. You can set up periodic distributions to reoccur automatically.

6. Custodial IRA

A Custodial IRA is an Individual Retirement Account that a custodian holds for a minor with an earned income. The custodian manages all assets until the child reaches age 18 or 21 in some states. All funds in the account belong to the child and he/she will reap the benefits of compounded growth. Additionally, the child will be able to use the funds for future expenses like college tuition. The account can be either a custodial Roth IRA or Custodial Traditional IRA.

7. Rollover IRA

A rollover IRA is a tax-free distribution of cash or other assets from prior employer-sponsored retirement plan into an IRA. In an Individual Retirement Account, this distribution to the second retirement plan is called a rollover contribution. A rollover IRA is usually a traditional IRA.

Who can Contribute to an IRA?

Anyone who earns an income can contribute to an IRA and enjoy the tax benefits. You can open an Individual Retirement Account through a personal broker, a bank, an online brokerage, federally insured credit unions, or through an investment company.

These institutions must have received Internal Revenue Service (IRS) approval to offer these types of accounts. With an IRA, you can choose to invest in a wide range of financial products, including bonds, stocks, mutual funds, and exchange-traded funds.

Can a Retired Person Contribute to an IRA?

Yes. If you have an income after retirement, you can contribute to an IRA. Some of these incomes includes wages, tips, salaries, bonuses, commissions, and long-term disability benefits.

Retirees can contribute to both Traditional and Roth IRAs. There are no age restrictions to contribute to both IRAs. You cannot set side distributions from other retirement accounts, dividends, or interest income to these accounts.

Summary of Types of Individual Retirement Accounts (IRA)

Individual Retirement Accounts (IRAs) are retirement savings accounts that offer tax advantages. They work somehow like 401(k), only that they do not need an employer to sponsor them. IRAs accrues interest based on the money you contribute to them. The more money you contribute; the more money you will have when you retire. The best time to withdraw from an IRA is after the age of 60 since an earlier withdrawal will incur a 10% early withdrawal penalty.

Read More