What are the different types of IRAs?
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“Verified by an expert” means that this article has been thoroughly reviewed and evaluated for accuracy.
BLUEPRINT
Updated 5:12 a.m. UTC Jan. 25, 2024
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Key points
- There are several IRA options.
- Tax advantages will vary based on the type of IRA.
- Contribution limits may vary based on your age.
Retirement planning is an essential aspect of securing your financial future. One way to do so is by taking advantage of individual retirement accounts.
“It’s important to consider IRAs for retirement because they are generally more tax-efficient than investing in taxable accounts,” said Jeremy Finger, a certified financial planner and founder of Riverbend Wealth Management. “Either you get a tax deduction upfront as with a traditional IRA, or you get tax-free growth as you would with a Roth IRA.”
Understanding the nuances of IRAs will help you choose one that suits your needs and goals, ensuring you are well prepared for your golden years.
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What is an IRA?
An IRA is an excellent vehicle for stashing money away for retirement.
“IRAs allow you to invest in a broad array of choices that give your money a chance to grow with significant tax benefits,” said Craig Reid, president and retirement advisor at Marsh McLennan Agency.
Roth and traditional IRAs are often the go-to options, but don’t overlook other contenders. Spousal IRAs, simplified employee pension plans, savings incentive match plans and other IRAs offer similar, and in some cases more favorable, tax and investment benefits.
Choosing the right IRA can be research-intensive. It depends on your income, employment status and whether your employer offers a retirement plan.
Types of IRAs
1. Traditional IRA
The leader of the pack, the traditional IRA is a favorite among individuals taking control over their retirement savings. The investment parameters for this IRA are:
- 2024 contribution limit of $7,000 for savers under age 50.
- 2024 contribution limit of $8,000 for savers 50 or older.
Your contributions may be tax-deductible. For instance, if your filing status is single, head of household and not covered by a retirement plan at work, you can deduct up to your contribution limit.
Tip: You can access more information on IRA deduction limits on IRS.gov to check whether you can claim a deduction on your federal tax return.
Also, if you take out money from your traditional IRA before age 59½, that amount might be subject to a 10% tax penalty. But there are a few exceptions to the 10% penalty. Usually, the exceptions involve some sort of hardship, such as using the funds to pay for health insurance premiums if you’re unemployed.
2. Roth IRA
A Roth IRA differs from a traditional IRA in that your contributions are made with after-tax dollars and qualified withdrawals are tax-free. The investment parameters for a Roth account are:
- 2024 contribution limit of $7,000 for savers under age 50.
- 2024 contribution limit of $8,000 for savers 50 or older.
The contributions you make to your Roth IRA account are not tax-deductible. This is because you are contributing after-tax dollars. Since your contributions are already taxed, your retirement withdrawals will be tax-free.
Roth IRAs are also more forgiving when it comes to early withdrawals. You can withdraw your contributions anytime without penalty.
If you’ve held your Roth IRA for at least five years and are older than 59½, you can withdraw your earnings without an early withdrawal penalty. However, early withdrawals on earnings might be subject to penalty fees.
3. SEP IRA
A simplified employee pension IRA, offers a convenient way for employers to set aside money for retirement, not just for themselves but for their employees too. Unlike traditional retirement plans, SEP plans have minimal startup and operational costs.
For an employee of your business to be eligible to enroll in this account, they must meet the following requirements:
- Be 21 years or older.
- Been a company employee for at least three of the last five years.
- Received at least $750 in 2024.
For the employer, the contribution limits are:
- Percentage based on the earnings limit of $345,000 in 2024.
- Limited every year to either 25% of earnings or $69,000 in 2024, whichever is smaller.
A plus with SEP IRA is that there is no vesting. That means any contribution that your employer makes becomes yours completely. That said, employees can’t contribute directly to their own SEP IRA.
4. SIMPLE IRA
A savings incentive match plan for employees IRA is a retirement savings option that allows both employees and employers to contribute to a traditional IRA. It is a perfect solution for small businesses that have yet to offer a retirement plan. Companies with 100 or fewer employees typically use this choice. It has the following contribution criteria:
- The employer will match up to 3% of the employee’s compensation (if the employee elects to contribute).
- The employer must contribute 2% of the employee’s compensation (even if the employee elects not to contribute).
- $16,000 contribution limit for 2024.
- 2024 catchup contribution of $3,500 for savers 50 or older.
The employer will select the contribution method annually, whether it’s a nonelective or matching contribution.
5. Nondeductible IRA
As mentioned, contributions to a traditional IRA are tax-deductible. But if you (or your spouse) have a retirement plan at work and your income exceeds certain limits, you won’t be able to deduct the excess amount. That doesn’t mean you can’t contribute to the IRA, however.
Though you won’t have a tax advantage on these contributions, you must still report them to the IRS using Form 8606. You might not see the point in nondeductible contributions, but the benefit is that you will receive tax-deferred growth on your earnings.
Properly reporting your nondeductible contributions can also save you money in the long run. This is because the government doesn’t want your money to be subject to federal income tax twice. By filling out Form 8606, you are officially documenting that a portion of the money in your IRA has already been taxed. Later, when you withdraw money from the account, a portion will be tax-free.
6. Spousal IRA
According to the IRS, an individual must have earned income to be qualified to contribute to an IRA. But for married taxpayers, there’s a way around this rule. Even if one spouse is not working or has a low income, the couple can still contribute to separate IRAs (either Roth or traditional) of their own. The contribution limits and criteria for a spousal IRA are:
- 2024 contribution limit of $7,000 for savers under age 50 and $8,000 for savers 50 or older.
- Couples must file a joint tax return.
The spousal IRA can be funded by either spouse, even if one spouse is making all the contributions. The only caveat is that the spousal IRA must be opened under the nonworking spouse’s name.
7. Self-directed IRA
Self-directed IRAs, in both traditional and Roth varieties, follow the same guidelines for eligibility and contributions as those same counterparts. But there’s one major difference — the types of assets you can hold in the account.
Unlike other IRAs that usually limit investments to conventional options such as stocks, bonds and mutual funds, a self-directed IRA allows you to own assets like real estate, gold and privately-held companies.
To establish a self-directed IRA, you must find a trustee or custodian experienced in handling these less traditional investments. Also, several transactions are prohibited within a self-directed IRA — such as borrowing money from it or using it as security for a loan — that the IRS considers equivalent to taking a distribution. These actions can result in taxes and penalties on the entire account.
This is a lot of information to digest. If you’re still not sure which IRA is best for you, here is a quick table highlighting the key points of each IRA mentioned above.
The IRA lowdown
So you’re ready to take control of your retirement? IRAs, or individual retirement accounts, are a great way to do that. Unlike a 401(k), IRAs don’t require an employer sponsor — so you’re in complete control.
But there are several IRAs to choose from, and it’s important to understand their differences to open the right account for you. Keep in mind that IRAs are meant to be long-term retirement savings accounts. If you take money out early, you could miss out on a lot of potential growth.
Frequently asked questions (FAQs)
The IRS does not restrict the number of IRAs an individual can own. However, there is a cap on the total amount individuals can contribute to IRAs annually, whether traditional or Roth accounts. In 2024, the IRS sets the contribution limit at $7,000 per year for those under 50.
It’s possible to have multiple Roth IRA accounts, but the IRS has set a limit on how much you can contribute to them.
Let’s say you’re under 50 years old, have two IRA accounts and want to contribute half the annual limit to each. Then, you would simply fund each account with $3,500, or half the annual limit of $7,000. You can contribute any amount to your IRAs (for example, $4,000 in one and $3,000 in another). But all of your contributions can not exceed $7,000 for 2024.
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