Breaking down the different types of IRAs

IRA, Retirement & Investing
on June 12, 2012

Today, less than twenty percent of all companies in America offer their employees a traditional pension. In fact, more than 10% of American companies do not offer their employees any type of retirement plan. To make matters worse, the quality of the investment choices in many employer-sponsored retirement accounts can vary wildly. This situation has left many workers, in a position where they have to plan and save for retirement on their own.

In addition, there is a growing number of people who own small businesses or are self-employed in this country. These people must plan and save for their own retirement entirely on their own. Fortunately, there are a variety of IRA accounts that have been designed for people in these situations.

Generally speaking, a “regular” or traditional IRA is the simplest or most basic type of IRA account. As long as a person has earned income in the past year and he or she is younger than 70½ years, he or she is eligible to contribute to this type of IRA account. This year, an individual may contribute up to $5,000 to an IRA, or up to $6,000 if he or she is at least 50 years old. Of course, a person must be able to prove that he or she has made this much money in the past year, or be married to a person who has made this much money in the past year in order to contribute this much.

The reason that most people invest in a traditional IRA is that their contributions are tax-deductible. This means that any money that is deposited in the account is not subject to federal income tax. Furthermore, the money that is invested in the account is allowed to grow tax-free. All money that is taken out of the account is subject to taxes, however.

It is important to note that there are some restrictions on withdrawals from a traditional IRA. An investor is allowed to begin taking distributions from his or her account as soon as he or she turns 59½. Furthermore, an investor is required to take minimum distributions as soon as he or she turns 70½. Withdrawals that occur before a person turns 59 ½ are subject to a penalty of 10% and the investor’s regular federal tax rate.

A Roth IRA is the other type of IRA available for individuals. While the contribution limits are the same as those for a traditional IRA, all contributions are considered to be taxable. Within the account, however, all money can grow tax free, and when the money is withdrawn there are no taxes due. There are some restrictions on the amount of income a person is allowed to earn in order to qualify to make a deposit into this type of account, however.

Unlike a traditional IRA, there are no requirements on how and when to take distributions. By law, the money in a Roth IRA never has to be taken out, making it possible to pass the account onto an heir. Furthermore, unlike a traditional IRA, all money that is deposited into a Roth IRA can be withdrawn at any time without penalty. All other money that is withdrawn before the investor turns 59½, however, is subject to a ten percent penalty and taxes at the investor’s normal federal rate.

With both of these types of IRAs and investor gets to choose the type of investments in the account. In general, investors can choose nearly any type of stock, CDs, money market funds, mutual fund, corporate or government bonds, or exchange-traded funds (ETFs).

A self-directed IRA is an ideal account choice for anyone who wants to choose investments that do not fall into these categories. Investment choices in a self-directed IRA account can include real estate, groups of mortgages or other loans, businesses, precious metals, and other commodities.

An investor with a self-directed IRA is required by federal law to have a trustee or what is termed a “qualified custodian” oversee the transactions that are made within the account. This person must also handle the disbursement of any money from the account.

A self-directed IRA is generally governed by the same rules and restrictions as a traditional and Roth IRA. There are some additional restrictions regarding the special types of investments that are allowed in the account. For example, an investor is not allowed to use any of the assets in one of these accounts for personal benefit until he or she reaches age 59½. This means a young person cannot place their primary residence into an IRA.

In addition to these three types of personal IRAs, there are two types of IRA for businesses. A Simplified Employee Pension or SEP IRA is a retirement account for someone who is self-employed or a business owner. Employers are allowed to make pre-income tax contributions to these accounts that are set up for their eligible employees as well as for themselves.

SEP-IRA accounts are available to any business, regardless of size. The accounts are considered to separate retirement plans that an employee can have in addition to a personal IRA, or other type of retirement account. It should be noted, however that a SEP-IRA can only be funded by an employer. This means that employees are not allowed to add their own money to the account. The employee always has full ownership of the account, and he or she can choose what type of investments the money in the account should be put into.

The amount of money that is contributed to a SEP-IRA is ultimately at the discretion of person’s employer, but there are some limits. The total amount deposited in a year cannot exceed 25% of the employee’s annual salary or 20% of a business owner’s net income, up to a maximum $50,000.

Withdrawals from a SEP-IRA generally follow the same rules as a traditional IRA. The owner of the account is allowed to withdraw funds as soon as he or she turns 59½. Withdrawals are mandates as soon as the account owner turns 70½. A person is allowed to roll over money from a SEP-IRA into a traditional IRA without having to pay penalties or taxes.

Finally, the Savings Incentive Match Plan for Employees or SIMPLE IRA is a type of retirement account that is available to businesses with less than 100 employees. This type of account can be set up like a 401(k) or an IRA. Also, SIMPLE IRAs come with less restrictions and set-up time than other types of employer sponsored retirement plans. This can make them a good choice for smaller companies that want to reward good employees but minimize their administrative costs.

With a SIMPLE IRA, employees can choose to make contributions to their account with pre-tax money. An employer is required to contribute a pre-set amount or percentage of matching funds. In general, the rules state that an employer must match at least the first 3% of their employee’s compensation or make contributions of at least 2% of each employee’s compensation to every employee’s account. Employees are always completely vested in their employer contributions. Owners of SIMPLE IRA accounts are allowed to withdraw funds at age 59 ½ without having to pay a penalty. Like a traditional IRA, they are required to start withdrawals by age 70 ½.

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