What is an IRA account?
This acronym stands for “Individual Retirement Account,” which serves as a type of savings that yields big tax breaks. For that reason alone, many people are looking into this possibility. The thing to remember is that unlike stocks, bonds, 401k and mutual funds, an IRA account is not an investment. Rather, it works as a holding place for assets.
Something else that makes an IRA unique is that it’s not provided by employers. Instead, this is a type of account that an individual chooses to open. However, there are options for small business owners as well as self-employed people. Another factor worth noting is that not everyone benefits from an IRA account in the same way. Each type has different rules, including:
- Eligibility (based on employment and income)
- Limits as to how much a person can contribute annually
- The amount of penalty should someone withdraw money before reaching the designated age of retirement
All in all, an IRA account is an excellent way for people to save money until they decide to retire.
Choosing an IRA Account
One of the most important decisions when opening an account is to select the appropriate type. Following are the different options.
For this, the account holder gets a tax break by deducting the amount of contributions on his or her tax return. As a result, the money in a traditional IRA grows tax-deferred. Simply put, contributors won’t have to pay income on the money saved until they withdraw it from the account.
One of the big advantages of a traditional IRA is that virtually anyone can contribute. However, there is one caveat. Sometimes, the salary the account holder earns can limit the amount of taxes deducted from contributions. Also, if that individual has a spouse with a retirement plan
through his or her employer, that too could impact the deductible amount.
To avoid a penalty when withdrawing money from a traditional IRA, a person must be at a minimum of 59 1/2 years of age. Sometimes, the account itself has additional requirements for withdrawal.
While a Roth IRA also offers a big tax break, it works differently from a traditional IRA. For the Roth option, there is no tax deduction on the contributions. However, the money in the account will grow tax-free, meaning while building up the funds, the account holder doesn’t pay on any gains. Also, when withdrawing money after retiring, the money is tax-free.
There’s another significant reason for opening a Roth IRA. The account holder can withdraw money at any time without paying the penalty. Even so, he or she still has to follow certain rules for taking money out before retirement. They’ll also find that this type of IRA has limits as to how much salary he or she can make. If the individual earns too much, there’s another option in what’s known as a backdoor Roth IRA.
What that means is that an individual would open a traditional IRA account but then, convert it to a Roth. Before automatically doing this, it’s always best to talk to a financial advisor. After all, the contributor wants to make sure that he or she gets the biggest tax break possible while growing the money in the account.
What makes a Self-Directed IRA different from the other types is that a person decides on which investments to add to the account. Along with stocks, bonds, and mutual funds, this might include a privately held business or real estate holdings. There are also some specific rules for a Self-Directed IRA with regards to eligibility and income.
SEP, the acronym for “Simplified Employee Pension,” is often ideal for self-employed individuals and small business owners. This particular IRA account is similar to the traditional type in that the account holder would get a tax deduction on his or her contributions. Also, the money grows tax-deferred.
If someone owns a small company and has employees eligible for a SEP IRA, the IRS mandates them to contribute to their accounts. For that, the amount added to the IRA has to be at the same rate as what the business owner contributes to his or her SEP account.
As an example, if the owner of the company puts 15 percent of his or her earnings into this type of IRA, the company would also have to put 15 percent of each employee’s earnings into their accounts.
In other words, if the company has three employees making $20,000, $30,000, and $40,000 respectively, the owner is responsible for adding $3,000, $4,500, and $6,000 into the accounts annually on behalf of them. A SEP IRA is a nice perk for current employees and an enticement for potential new hires.
A Simple IRA account is specifically for smaller businesses that have 100 employees or less. In this case, employees make contributions themselves with a maximum per year of $13,000. For employees over the age of 50, there is an extra $3,000 annual contribution allowed to help them catch up.
With a Simple IRA, the amount employees contribute reduces their taxable income for that year. However, the money grows tax-deferred. Compared to other retirement options for small businesses, including a 401k, setting up a Simple IRA account is much quicker and easier.
Sometimes, the government refers to an Inherited IRA as a Beneficiary IRA. Regardless, the two are the same. Because this has to do with an inheritance, there are specific rules that people must follow, which vary depending on the individual’s relationship with the deceased party. Unless someone adheres to these rules, he or she could end up paying a large amount of money in taxes.
Starting an IRA Account
Because of all the differences of the various account types, it’s always in your best interest to speak with a trusted financial advisor before making the next step. That professional will look over your situation and suggest the appropriate IRA account. An advisor’s goal is to help clients choose an account that will grow their money the quickest, save on taxes, and have little to no penalty for early withdrawal.
While putting money aside for retirement at an early age is always recommended, remember, it’s never too late to plan for the “golden years.”