There are many different ways to save for retirement. In the below article I will outline four IRAs or Individual Retirement Accounts that you can consider for your personal retirement savings. I have included a chart to help with your decision.
A traditional IRA is a type of account that allows you to save a certain amount each year. In 2013 and 2014 the amount is $5,500 per year unless you are at the age of 50 or older in which case you can save $6,500 per year. This amount is set by the IRS and has increased over time. The benefit of saving in this type of account is any amount of contributions can be deducted from your taxes. The money in the account then grows tax free until you take distributions. These distributions are then taxed as ordinary income. Distributions can be made without a penalty at age 59 and ½. Distributions taken before this age may be subject to an additional 10% tax unless you meet one of the IRS’ exceptions. Contributions to Traditional IRAs can be made for the previous tax year up until the tax deadline for that year. For example, you can still make your 2013 contribution until the April tax deadline. This is not allowed for Roth IRAs. However, if you missed the deadline for a Roth IRA contribution you can make your Traditional IRA contribution and then do a Roth Conversion. Also, if you are covered by a retirement plan through your employer such as a 401k or Pension your contribution may not be completely tax deductible.
Traditional IRAs allow for a tax deduction up front and Roth IRAs do not. However, you do not have to pay taxes when take distributions. This makes Roth IRAs more suitable if you think you will have a higher tax rate during retirement. Distributions can be made without tax and penalty at age 59 and ½.
A nice feature of a Roth IRA is that you can withdraw your contributions at anytime without penalty because you have already paid taxes on this money. This means a Roth IRA can be used as an emergency fund. You cannot do this with a Traditional IRA without being hit with the early withdrawal penalty. You can contribute to both a Traditional IRA and a Roth IRA in the same year but only up to the combined maximum of $5,500 ($6,500 if age 50 or older) i.e. you cannot contribute $11,000 in 2013, only $5,500 but it doesn’t matter which type of account(s) you choose.
There are also income limits on contributing to a Roth IRA. For single or head of household your ability to contribute starts phasing out at $112,000 (2013).
A SEP IRA is a simplified employee pension. It can be established by an employer or someone who is self-employed. SEP IRAs are basically the same as a Traditional IRA except the contributions are made by the employer. The contributions can be adjusted each year and must be uniform for all employees. Contributions are limited to the lesser of either 25% of an employee’s compensation or $51,000 (2013). There are no catch-up contributions for those of you who are age 50 or older. Once established it acts much like a Traditional IRA where you (employer/self-employed) receive the tax deduction up front and pay the taxes when you distribute the money. Just like the Traditional and Roth IRAs there is a 10% penalty if distributions are taken before the age 59 and ½.
This is another type of employer IRA plan but allows for employee contributions through salary deferral and employer contributions. This makes it similar to a 401k but with less administration. The employee can contribute the lesser of $12,000 or 100% of compensation (2013). . The employer sponsoring the SIMPLE will also make a matching contribution based on a percentage of the employee's pay. This plan does allow for catch-up contributions for age 50 and up. Unlike 401k plans a SIMPLE IRA does not allow loans. One other potentially important difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).
It is not really a matter of which type of account is better it is more about which is better for you. Each of these types of accounts has advantages. You should look at your personal situation to determine which helps you better achieve your goals.
If you are self-employed consider utilizing a Traditional IRA or a Roth IRA first and then, if you want to save even more, creating a SEP IRA as this requires additional paperwork (written agreement) and can become more complicated if you grow and add employees.
If you still need some help on choosing the best type of account for you feel free to reach out to us anytime.