In our series of IRA articles, Wealth CAP, a leader in retirement income planning, will review the types of IRAs available and their different benefits, stipulations, and conditions, so you can make the right choice for you. Wealth CAP utilizes IRAs in an asset allocation we call dynamic bucketing portfolios (DBPs). Contact us today for more information.
TYPES OF IRAS
An IRA is an individual retirement account set up by the federal government in the 1970s to help individuals plan for retirement. They offer tax advantages and are great instruments to supplement your retirement income.
Three Main Types of IRAs
- Traditional IRA. This IRA type is only known as traditional to distinguish it from the Roth IRA. Traditional IRAs allow anyone to contribute to it with no income limits. The growth is tax-deferred, meaning you won’t pay taxes on the capital gain until you withdraw it. You can use this money to pay for college expenses with no early distribution penalty, but you will have to pay taxes on it (which you would anyway if you took it out later). Another added benefit is you can use $10,000 of it to buy your first home (with taxes owed on this amount withdrawn). The IRS does put limits on the amount you can deduct from your taxes when you reach a certain income level. For 2019, you can contribute $6,000 plus another $1,000 for those over age 50. All withdrawals are taxed, and minimum distribution requirements kick in at age 70 ½. Contributions must be earned income.
- Roth IRA. The Roth IRA is in essence the opposite of the traditional IRA in terms of tax advantages. Withdrawals are completely tax-free, but contributions are not tax deductible (so there’s no upfront tax break). However, your contributions grow tax-free, and you pay no taxes on the withdrawn amount because you have already paid taxes on the money you put in. However, you may still be subject to early withdrawal penalties. Remember an IRA is an account that holds your investments, rather than an investment itself. The money is invested by your IRA custodian in mutual funds, stocks, ETFs (exchange-traded funds), or alternative investments, such as real estate. The contribution limit is the same for 2019 as for Traditional IRAs — $6,000 or add an extra $1,000 for a catch up contribution if over the age of 50. There are no minimum distribution requirements, meaning you can pass on your Roth IRA to beneficiaries. Roth IRAs can be used as supplemental income once you hit 59 ½ if you’ve had the account for at least five years without paying taxes. Contributions must be earned income. So what’s the disadvantage to a Roth IRA? Believe it or not, earning too much money. The amount you can contribute to a Roth IRA begins to shrink at certain thresholds for modified adjusted gross income, and it keeps shrinking as income rises, until your ability to contribute is eliminated completely. The federal government figures if you make over a certain amount of money, you shouldn’t need help from the federal government to retire. But don’t fear — there is a government loophole where you can have a Roth IRA if you exceed the income threshold via a backdoor Roth IRA.
- Rollover IRA. A rollover IRA is where you take money from an employer-sponsored retirement plan (such as a 401k) and put it in an IRA account. Here, you can preserve the tax-deferred status of your retirement assets, without paying current taxes or early withdrawal penalties at the time of transfer. A rollover IRA can provide a wider range of investment choices that may meet your goals and risk tolerance, including stocks, bonds, CDs, ETFs, and mutual funds, rather than your employer-sponsored plan; however, every employer plan is different so check with your employer administrator for details. Do note: you’ll have to rollover your employer-sponsored money into a traditional IRA unless the money was sitting in a designated Roth 401k plan. However, if you roll over pre-tax money into a Roth IRA, this may become a taxable event. Either way a rollover IRA has the potential to help minimize future taxes and maximize retirement savings. A rollover IRA is utilized mostly when a person changes jobs or retires and can’t take their employer-sponsored retirement with them.
OTHER TYPES OF IRAS
These types of IRAs are in general a specialized type of either a traditional IRA or a Roth IRA.
- SEP IRA. A simplified employee pension (SEP) IRA is a type of traditional IRA that is set up and funded by an employer for their employees. The employer gets tax benefits for administering these IRAs. Just like a traditional IRA, earnings grow tax-free and distributions in retirement are taxed. The benefits of a SEP IRA include much higher contribution limits ($56,000 in 2019), the employer must contribute equally (percentage-wise) to all employee accounts, and the amount of contribution can vary year to year based on the business’s cash flow needs. Only businesses contribute to this IRA.
- Nondeductible IRA. These IRAs are primarily for those who cannot contribute to a Roth IRA or a traditional IRA. Contributions to this type of IRA are not deductible, but you gain tax-deferred growth until you withdraw the funds.
- Spousal IRA. Because all contributions to IRAs have to be from earned income, if a spouse doesn’t work in theory, he or she can’t contribute. A spousal IRA is the workaround, which allows the spouse to open his or her own IRA (either traditional or Roth) with mutual earned income. However, the couple must file a joint tax return and the contribution limit is based on the working spouse’s eligibility information. The total contribution can only be double the spouse’s contribution limit.
- Simple IRA. A simple (savings incentive match plan for employees) IRA is in essence a SEP IRA; however, a simple IRA allows for individual contributions and not just employer contributions. It is also very similar to an employer-sponsored 401k. This was designed for small companies and self-employed people who can’t for many reasons set up a traditional employer-sponsored 401k plan. Some things to note with a simple IRA: contribution limits are lower than a 401k plan, employers are usually required to add in up to three percent of a matching contribution by their employees, catch-up contributions are allowed, income must be earned by the employee (usually minimum of $5000), and early withdrawal penalties can be steep.
- Backdoor Roth IRA. Don’t let the name fool you: a backdoor Roth IRA is legal, made possible in 2010 when the federal government removed the income limits for IRA conversions. In essence, a backdoor IRA is a traditional IRA converted to a Roth IRA. You’ll have to pay taxes, but in the end you’ll have tax-free income in retirement. It works like this: you open a traditional IRA (which has no income limits); you convert the traditional IRA account to a Roth IRA; you pay taxes on the money you contributed to the traditional IRA, and then you’ll have to pay taxes on the gains (which grew tax-free), which you’ll have to report as income on your federal income tax return.
- Self-directed IRA. A self-directed IRA is very similar to a traditional and a Roth IRA. The difference lies in the investments that can be used. Most IRAs use very traditional investment instruments, such as stocks, bonds, and mutual funds. A self-directed IRA allows real estate, gold, and privately held companies to be used in the mix. A self-directed IRA requires an IRA custodian or trustee who specializes in self-directed IRA to administer the IRA. Some assets are excluded, such as life insurance and collectibles. And there’s a no self-dealing rule, which applies. An example of this is spending the night in a rental property your IRA is invested in. This could yield severe penalties. These IRAs are recommended for those interested in higher returns and more diversification of assets. They work in the same way as other IRAs: you open an account and contribute money to the account.
IRAs are powerful instruments to consider in your retirement savings plan. If you start at a young age, you can build up quite the nest egg with IRAs that will yield huge benefits when you retire. Wealth CAP believes investing in IRAs is a critical component of your retirement income plan. Sitting down with a qualified financial advisor to help you determine your financial goals for the future is imperative and prudent. After all, if you don’t know where you’re going, how will you expect to get there?
Through our dynamic bucketing portfolios (DBPs), which uses market investments, alternative investments, and safe investments, distributed to your particular needs, you’ll grow your investments, gain liquidity, and be protected. With a comprehensive retirement plan, you can be prepared for whatever your future holds. Wealth CAP can show you how to plan for retirement, review your financial and lifestyle goals, and map out a financial plan for you so you can get to where you want to go. Contact us today!