IRAs help you save for retirement, but they also provide some tax benefits today. Those benefits depend on the type of IRA you contribute to and how. Below is an overview of the different types of IRAs and the unique aspects of each.
Traditional IRAs consist of two types of contributions: deductible contributions and nondeductible contributions.
You’re eligible for deductible contributions if you meet one of the following criteria:
- You are not actively participating in an employer-sponsored retirement plan, or
- You are an active participant and your adjusted gross income (AGI) does not exceed a certain level. (Note: the levels vary from year to year, so don’t assume last year’s standards are the same in this tax year.)
One of the primary benefits of making deductible contributions to a traditional IRA is the potential to reduce your current tax bill. The amount you contribute to a traditional IRA (a maximum $5,500 if you’re under 50 years old and $6,500 if you’re 50 and older per tax year) is deductible. The IRA earnings are tax-deferred, meaning they are not taxed until you make a withdrawal. If you make a withdrawal before age 59 ½, there is a 10% early withdrawal tax penalty. You must withdraw a minimum amount by the year you turn 70 ½. Every dollar of a deductible contribution is taxed in full upon withdrawal.
You can make nondeductible contributions to a traditional IRA regardless of whether or not you’re participating in your employer’s retirement plan or your AGI. However, nondeductible contributions do not lower your current tax bill. The earnings are tax-deferred, though, and are taxed on distribution. The contributions themselves are not taxed upon distribution because you have already paid taxes on those funds. That’s why the nondeductible contributions do not lower your current tax bill. The age parameters on withdrawals are the same as those for deductible contributions.
If it comes down to contributing to a nondeductible traditional IRA or a Roth IRA, you would be better off choosing the Roth IRA. The tax benefit package is better. The same annual contribution limits apply, meaning the total amount you can contribute to traditional and Roth IRAs is the same as it would be if you contributed to just one type of IRA. With a Roth IRA, those contributions are not deductible.
Earnings on a Roth IRA are tax-deferred and tax-free if they are paid out under the following circumstances:
- Five years have passed since you made the first contribution, AND
- You meet one of the following qualifications:
- You are at least 59 ½
- Death or disability
- You use the money for first-time homebuyer expenses (up to $10,000 in a lifetime)
Added benefits of a Roth IRA
While contributions to a Roth IRA are not deductible, this type of IRA has other benefits. For starters, you don’t have to withdraw minimum amounts at a certain age. Not only are you free from the withdrawal mandate, but you can continue making contributions after age 70 ½, too. This makes the Roth IRA a good wealth building tool for families.
SEP-IRA and SIMPLE IRA
Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs are great options for small businesses that want to provide their employees with a retirement plan. Contributions are made in the employee’s name, but there is no annual limit on the contributions like exists with Traditional and Roth IRAs. Distributions are similar to the tax rules associated with deductible IRAs.
Need help deciding what’s right for you?
It’s a lot to consider and navigate when thinking about your future. Sometimes rules (like limits) change. If you want some professional insight on IRAs or any other potentially deductible retirement contribution, give us a call. You can also learn more about us here. We’re here to serve you.