Individual Retirement Accounts (IRAs) have evolved since they were established more than twenty years ago. They now include such variations as SEP IRAs, Roth IRAs, SIMPLE IRAs, and more. IRAs provide the same tax-deferred benefits as 401(k) and similar employer-sponsored plans (though Roth IRAs work a little differently) and allow you to decide how your funds will be invested.
If you have employment income (including self-employment) in any year, you can make contributions to an IRA. The annual contribution limit was $6,000 as of 2020, and you’re allowed to make an additional catch-up contribution of $1,000 once you reach age fifty. You can set up an IRA through most banks and financial institutions, or through a mutual fund company or broker. You can start making withdrawals at age fifty-nine and a half, and, unless it is a Roth IRA (an IRA that isn’t taxed upon distribution), you must start doing so by age seventy-two. As with 401(k) plans, income tax and a 10 percent penalty apply to any funds you take out early unless you qualify for a waiver of the penalty (for very high un-reimbursed medical expenses, qualified higher education expenses, or up to $10,000 for first-time homebuyers).
If you have access to an employer-sponsored retirement plan with matching contributions, get your match before putting money into an IRA. If you don’t have access to an employer-sponsored plan, contribute as much as you can to your IRA.
Traditional (or regular) IRAs give you a current tax deduction for your contributions, and allow your money to grow tax-deferred until you start making withdrawals. Depending on your income, your filing status, and whether you have a qualified retirement plan at work, your IRA contributions may not be fully tax-deductible. However, you can still make nondeductible IRA contributions and benefit from the tax-deferred growth inside the account even if you don’t qualify for the current tax deduction. If you (and your spouse) aren’t eligible for any employer-provided retirement plan, you can deduct the full contribution to an IRA regardless of your income level.
If you own a traditional IRA, you’ll have to begin taking required minimum distributions (RMDs) from it starting no later than April 1 of the year following the year in which you reach age seventy-two. If you don’t take your RMD every year, you could face an IRS penalty of 50 percent of the amount you were supposed to withdraw.
There are several important distinctions between traditional IRAs and Roth IRAs. Traditional IRA contributions are tax-deductible as long as you qualify with the eligibility restrictions. Roth IRA contributions are not. Traditional IRAs grow tax deferred until you withdraw the funds at retirement, and then they’re taxed at your regular income tax rate. Roth IRA growth and earnings are never taxed, as long as you follow all the rules. Unlike traditional IRAs, there’s no requirement to ever withdraw money from your Roth IRA, even after you’ve reached age seventy-two.
You can contribute to a Roth IRA even if you participate in an employer-provided retirement plan, and the income limits for that are higher than for deductible IRA contributions. However, high earners may be locked out of Roth contributions altogether, regardless of whether they have access to employer plans. Income limits change regularly. Visit the IRS website at www.irs.gov for the latest rules.
It can be difficult to determine whether you’d come out ahead in the long run with a traditional or a Roth IRA. It depends on a number of factors, such as how long before you retire, when you plan to start taking money out, and your tax bracket now and expected tax rates during retirement. There are benefits to Roth IRAs in addition to tax-free earnings. You can withdraw your contributions—but not any earnings—before age fifty-nine and a half without owing taxes or penalties. You can withdraw up to $10,000 in earnings without penalty to buy your first home if the money has been in the Roth IRA for at least five tax years, to pay medical expenses exceeding 7.5 percent of your gross income, to pay college expenses for certain family members, to pay for health insurance if unemployed for at least twelve months, or if you’re unable to work because of disability. Any other earnings withdrawals before the age of fifty-nine and a half will be subject to the penalty and taxes.
Regular IRA or Roth IRA?
If your income exceeds the limits for a traditional IRA (and you are an eligible participant in a qualified plan), you can still contribute, but it won’t be tax-deductible. If you don’t qualify for the tax deduction, then a Roth IRA is a good choice as long as your income falls under the maximum for that year. If the Roth IRA is not an option because your adjusted gross income (AGI) is too high, you can make a nondeductible contribution to a traditional IRA. When you start withdrawing from this IRA, a portion of each distribution will be considered a nontaxable return of your nondeductible contribution.
Just as you diversify your investments, you should diversify your tax strategies. Since you never know what’s going to happen with tax laws in the future, you should avoid having all your eggs in one “tax basket.”
As you decide how much to save in each type of account, consider your income, your prospects for the future, and your thoughts on future legislation. If you are relatively young and just starting your career, chances are that you are not earning much money (and you’re therefore paying taxes at a relatively low rate). In that case, getting a deduction may not be worth much to you—and you might prefer the potential to take your money out tax-free in retirement. In addition, the ability to take back your contributions at any time may serve as a safety valve. You don’t need to worry about taxes and penalties if you need to get that money back.
As you move up the income scale, a deductible contribution to your IRA or 401(k) can save you a bundle. Some people prefer to get something of value today instead of hoping for something of value later. They’d rather take a deduction because they are certain they can get it. They are not as certain about future tax law changes.
Some employer-sponsored retirement plans allow Roth-type contributions. In other words, the benefits of a Roth IRA became available in some 401(k)s and 403(b)s. Previously, you could only make pretax (or deductible) contributions to these plans. For many young people, the Roth 401(k) is an attractive option.
How is a Roth 401(k) different from a Roth IRA? For starters, you can make a larger contribution into a Roth 401(k) account. You can allocate the maximum 401(k) contribution ($19,500 in 2020) toward Roth-type dollars without the AGI limitations of Roth IRAs. However, you can also split contributions—putting 5 percent of your pay in pretax and 5 percent of your pay in after tax, for example. In addition, you can contribute to a Roth 401(k) regardless of how high your income is. Unlike Roth IRAs, though, money in Roth 401(k) accounts is subject to required minimum distribution (RMD) rules, meaning you must start taking withdrawals at age seventy-two.
Roth 401(k) simply adds an additional “bucket” of money to your retirement plan. Your investment mix doesn’t change—it’s just the tax treatment that changes. If you leave your job, your money is still portable. However, you have to keep Roth-type money separate from traditional (deductible) money. For example, you’d roll your Roth 401(k) money into a Roth IRA, and you’d roll your traditional 401(k) money into a traditional IRA.
For small businesses, costs are always an issue. Small employers don’t have the resources that large enterprises do. However, they have to compete against larger organizations for good employees. As a result, many small businesses will offer plans that help people save for retirement while keeping costs low. SIMPLE IRAs and SEPs allow employers to offer incentives with very low administrative cost.
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a plan that may be offered by businesses with no other retirement plans and with fewer than 100 employees. As in 401(k) plans, your contributions and earnings are tax deferred. You can contribute up to $13,500 a year with an additional “catch-up” amount of $3,000 for those fifty or over. The employer must either match 100 percent of your contributions, up to 3 percent of your salary, or contribute 2 percent of compensation for each eligible employee, even those who don’t contribute to the plan.
A Simplified Employee Pension (SEP) IRA is similar to a SIMPLE IRA, except that generally only your employer can contribute (some employees may be able to make traditional SEP IRA contributions). The disadvantage of this plan for most employees is the lack of control over how much money goes into your plan. However, if you’re self-employed, these plans can help you save a lot of money without a lot of paperwork. In that situation, you count as both the employer and the employee at the same time. The limit on employer contributions to a SEP is 25 percent of your compensation up to a maximum of $57,000 in 2020. With both the SIMPLE IRAs and the SEP IRAs, you may also be able to invest in a personal traditional or Roth IRA. You can find full details and specific rules for setting up and funding these plans on the IRS website at www.irs.gov.
Solo 401(k) plans are among the most powerful options available to small businesses, but they only work for a one-person (or married couple) business. They share many of the characteristics of a standard 401(k) plan, including the ability to take loans. However, they are less expensive to administer. If you do any freelance or contract work, consider opening a Solo 401(k) plan. In addition to your “salary deferral” contributions, you can give yourself a profit-sharing contribution of up to 25 percent of compensation.