IRAs can play an important role in a retirement investment plan. However, there are many different types of IRAs to consider, each with its own rules and requirements when it comes to taxes, liquidity, and withdrawals.
An IRA is an incentivized savings vehicle, designed to motivate people to invest for retirement. “The government gives a tax advantaged status to these accounts, which you really don't get anywhere else,” explains John DeYonker, head of investor relations at Titan.
Here’s a look at the different IRA accounts investors can choose from when building a retirement savings strategy.
What is an IRA?
Individual retirement accounts (IRAs) are tax-advantaged, retirement-focused accounts held with financial institutions such as banks, credit unions, and brokerages. Funds deposited in an IRA may be pre-tax or post-tax, depending on the type of account. Those funds can be invested in a variety of assets and securities such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, and even real estate.
The contributions and gains are meant to stay in the account until the investor reaches age 59½. The money can be withdrawn at any time; however, if it’s withdrawn before the age threshold, the investor may have to pay a penalty.
7 types of IRAs explained
The rules governing when an investor pays taxes on IRA funds—among other things—vary based on the type of IRA.
1. Traditional IRA
A traditional IRA is a tax-deferred retirement account that offers deductible savings. This means that contributions made into this account throughout the year may be deducted from the investor’s taxable income. The actual amount that an investor can deduct from their taxes depends on how much they contribute to the IRA, their total income, and whether they (or their spouse, if applicable) have another retirement plan offered through their employer.
When an investor withdraws from this kind of account in retirement, those withdrawals (also known as “distributions”) are taxed as income. Required minimum distributions (RMDs) begin at age 72 for traditional IRAs, though investors can begin withdrawing funds at 59½ (certain circumstances allow for earlier distributions without penalty).
For 2021 and 2022, the contribution limit for traditional IRAs is $6,000 per year. If an investor is 50 or older, they can make an extra $1,000 in catch-up contributions, bringing their annual limit to $7,000.
2. Roth IRA
A Roth IRA is another type of retirement savings account. Unlike a traditional IRA, contributions into a Roth IRA are made by the employee with after-tax dollars. These contributions are not deductible at the time that they’re made. However, when an investor withdraws funds from these accounts, they do not have to pay taxes on them. That means the funds in a Roth IRA can grow tax-free over time.
Roth IRA account owners can also withdraw their original contributions from the account at any time without penalty (not the gains). To withdraw gains without penalty, owners need to be at least 59½ and have held the account for at least five years. Some circumstances allow for tax- and penalty-free withdrawals.
Like traditional IRAs, Roth IRA contribution limits are a maximum of $6,000 per year (or $7,000 for those 50 and older). This type of retirement account is only offered to individuals who meet certain income requirements based on their tax-filing status.
Since there are no RMDs on Roth IRAs, owners can keep the money in the account indefinitely. However, when the account owner dies and passes the Roth IRA to a beneficiary, they are required to withdraw all the funds within 10 years.
3. SEP IRA
A simplified employee pension (SEP) plan is a retirement account for small business owners, their employees, and other self-employed individuals. It offers higher contribution limits each year compared to traditional or Roth IRAs and allows business owners to contribute to employees’ accounts.
SEP IRA contributions are made with pretax dollars. Unlike other types of IRAs, SEP IRA contributions only come from an employer. Withdrawals, which can be taken at age 59½ without penalty, are taxed as ordinary income.
Contributions into a SEP IRA can be the greater of $61,000 for 2022 or 25% of the employee’s annual compensation. Employers must open and contribute the same amounts to each qualifying employee’s SEP IRA account. Employees are fully vested in their SEP IRA accounts from the beginning.
RMDs on SEP IRA funds begin at age 72. Early withdrawals (before age 59½ if a qualifying situation does not exist) are subject to income taxes and a 10% penalty.
4. SIMPLE IRA
With a Savings Incentive Match Plan for Employees, or SIMPLE IRA, both employees and employers can contribute to an employee’s retirement savings plan. SIMPLE IRA plans are available to small businesses (with 100 or fewer employees) and are only allowed if the employer does not offer any other retirement plan.
With SIMPLE IRAs, the employer must contribute to the account every year, but employees don’t have to. Employees are eligible as long as they earned $5,000 the previous two years or expect to make at least $5,000 in the current year. Employees are fully vested in the funds from day one.
Elective deferrals by employees are limited to $14,000 per year for 2022. (This rises to $17,000 if the employee is 50 or older.) Employers must either contribute 2% of the employee’s annual compensation—regardless of how much the employee contributes—or match employee contributions dollar for dollar, up to 3% of the employee’s annual compensation.
Withdrawals from a SIMPLE plan are allowed at age 59½ without penalty as long as the account has been open for more than two years. If funds are withdrawn early, the account owner is subject to taxes and a 10% penalty. If the early withdrawals occur less than two years after the account was established, the penalty is 25%.
5. Nondeductible IRA
A Roth IRA allows for tax-free withdrawals in retirement. However, individuals who surpass certain income thresholds cannot qualify for a Roth IRA. A nondeductible IRA works similarly, but is still accessible to those who don’t meet the Roth IRA income requirements.
With a nondeductible IRA, investors make after-tax contributions, as they would with a Roth IRA. However, account holders must pay income tax on any investment gains they recognize when they take distributions.
6. Spousal IRA
With a spousal IRA, a working spouse can contribute to an IRA on behalf of their non-working spouse. These contributions are limited to the lesser of either $6,000 (or $7,000, if 50 or older) or the combined gross income for both the investor and their spouse, minus their spouse’s contributions.
The maximum combined amount that can be contributed to the IRAs in a given year is between $12,000 (if both spouses are 50 or younger) and $14,000 (if both spouses are over 50).
7. Self-directed IRA
Self-directed IRAs, or SDIRAs, are retirement accounts that are actively managed by the account holder themselves. SDIRAs are held by custodians—such as a brokerage firm—and can invest in a range of assets and securities that the typical IRA cannot. This includes many alternative assets, like promissory notes, real estate, and even tax lien certificates.
An investor who chooses to self-direct their IRA may have more flexibility than an investor whose IRA is managed by a custodian. With that flexibility, however, comes an increased investment risk of volatility, high fees, and even fraud.
Choosing the best IRA
With so many different IRA account options, it can be difficult for investors to decide which is suitable. To help, they can consider the following questions:
- Do I expect to be in a higher tax bracket in retirement than the one I’m in now, or will it likely be lower or the same?
- What retirement plan options does my employer—or my spouse’s employer—offer? Will the employer contribute to the account in addition to any contributions made by the employee?
- Do I need the flexibility to withdraw contributions before turning 59½?
- How much do I (and my spouse, if applicable) make each year, and what do I qualify for in terms of IRAs?
- Do I want to manage the money myself or would I prefer to have a professional/brokerage do it?
How to open an IRA
In most cases, as with a traditional or Roth IRA, opening an account is a straightforward process.
First, investors choose the financial institution to open their account. This could be a bank, credit union, brokerage, or any number of other institutions.
Next, they choose an IRA based on their financial goals.
Opening an account involves providing certain personal information, such as name, date of birth, address, phone number, Social Security number, and email address, though requirements vary. Investors may also be asked to name a beneficiary for the account.
Once the account is open, it needs to be funded. This can typically be done by ACH transfer, check deposit, or wiring funds. Investors can also decide how they’d like to make ongoing contributions.
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