Types of IRA Investments

When planning for retirement, understanding the variety of investments you can hold within an IRA is essential for making informed decisions that maximize your savings and support your long-term financial goals.

An IRA, or Individual Retirement Account, is a tax-advantaged account that allows you to hold a variety of investments, helping you grow your retirement savings more efficiently. For example, a Roth IRA can help eliminate income taxes on your earnings when you retire as long as certain conditions are met. Alternatively, if you prefer to save on taxes now, a traditional IRA allows you to make tax-deductible contributions, reducing your taxable income today.

IRAs are one of the most popular retirement savings tools in the U.S. According to the U.S. Census Bureau, more than 18% of working-age Americans have an IRA, making it the second-most common retirement account after 401(k)s.

This article will explain all you need to know about the various types of IRA investments, including their eligibility and contribution limits. A financial advisor can also help guide you in making retirement planning decisions for your specific situation.

Types of IRA Investments

Each type of IRA comes with unique tax advantages and eligibility requirements based on income. Understanding these differences can help you choose the best option for your retirement strategy.

Traditional IRA

A traditional IRA is an individual retirement account to which you make pre-tax contributions. In other words, you can deduct this money from your taxable income when filing your tax return. For example, if you invest $6,000 in a traditional IRA, it could reduce the amount of your taxable income by $6,000.

These contributions are usually fully or partially tax-deductible. Your money will grow tax-deferred until you withdraw it from the IRA account. The withdrawals would then be taxable as ordinary income based on the tax rate at that time.

Eligibility: Anyone with an earned income (such as wages or self-employment income) can open and contribute to a traditional IRA.

Contribution and deduction limits: The IRS has annual contribution limits for all types of IRAs. For 2024, the contribution limit is $7,000 for individuals under 50, while those aged 50 and over can contribute up to $8,000 annually, taking advantage of the catch-up provision.

Your contribution may not be fully deductible if your income doesn’t meet the IRS’s modified adjusted gross income (MAGI) limit. The amount you can deduct depends on your filing status, income level, and participation in other retirement plans.

Early withdrawal penalties: Once you reach the age of 59½, you can withdraw your funds from a traditional IRA without penalties. Withdrawals are subject to a 10% penalty and income taxes if you take money out before you turn 59½. You might not face a penalty for using the money for educational expenses, buying your first home, or specific medical expenses.

Required minimum distributions (RMDs): Once you turn 73, you must begin taking RMDs from your traditional IRA. If you don’t, you could be hit with a 50% tax penalty of the amount you were required to withdraw.

Roth IRA

A Roth IRA allows you to make after-tax contributions and grow your money tax-free. Roth IRA contributions are not tax-deductible, so you don’t get immediate tax benefits.

Eligibility: You can contribute to a Roth IRA if your earned income exceeds the amount you want to contribute and your income meets the IRS guidelines.

Contribution qualifications: The amount you can contribute to a Roth IRA depends on your filing status and modified adjusted gross income (MAGI). As your MAGI approaches the upper limit, your contribution amount may be reduced or “phased out.”

Roth IRA phase-out ranges:

Contribution limits: For 2024, you can contribute up to $7,000 annually if you’re under 50, or $8,000 if you’re 50 or older. The extra $1,000 per year is considered a catch-up contribution.

Qualified distributions: You can withdraw your contributions and earnings tax and penalty-free if the account has been open for five years and you’re at least 59½ years old. If these conditions are not met, withdrawals of earnings may be subject to penalties and taxes.

Unlike a Traditional IRA, you don’t need to take the required minimum distributions with a Roth IRA.

Self-Directed IRA

A Self-directed IRA is a specialized retirement account that allows you to invest in a wide range of alternative assets, such as real estate and precious metals.

Conventional IRA portfolios include stocks, bonds, and mutual funds. In contrast, a self-directed IRA offers greater diversification of your assets.

Self-directed IRAs are similar to the regular traditional or Roth IRAs. It depends on whether you are looking for tax-deferred growth (traditional IRA) or tax-free growth and withdrawals in retirement (Roth IRA).

The necessity of a custodian: To open a self-directed account, you need to work with a custodian that handles this type of account. The custodian is the bank, brokerage, or other financial institution where you open your IRA account. Remember that they are not legally allowed to give you financial advice.

Contribution limits and early withdrawal penalties: Both types of self-directed IRAs (traditional and Roth) have the same contribution limits and early withdrawal rules as regular IRAs. Similarly, you’ll need to take the required minimum distributions once you turn 73.

Complex Tax Rules: The IRS imposes specific rules that apply to all IRAs, but these are particularly relevant for self-directed IRAs. For instance, if you invest in real estate through an SDIRA, it must be used strictly for investment purposes and not for personal use.”

High returns and high risks: A self-directed IRA can potentially yield higher returns; however, it also comes with significant risks, including higher volatility and potential for loss.

We recommended reviewing the SEC alert before investing in a self-directed IRA to understand the potential risks.

SEP IRA

A SEP (Simplified Employee Pension) IRA is a retirement savings account intended for self-employed individuals and small business owners. Your contributions to your SEP IRA are tax-deductible, meaning your taxable income will be lower. Funds in a SEP grow tax-deferred, and when you withdraw them, they will be taxed as regular income.

A SEP IRA differs from a traditional IRA in that the amount you can contribute is based on the profits you make in your self-employed business.

Eligibility: Anyone who owns a business or is self-employed can open a SEP IRA.

Employee Eligibility: Employees aged 21 or older earning at least $750 in 2024 are eligible for SEP IRA accounts. They must also have worked for the employer for at least three of the past five years.

Contribution Limits: Business owners can contribute up to 25% of an employee’s total compensation or up to $69,000 for the 2024 tax year, (whichever is less). Moreover, employees cannot defer salaries for SEP contributions.

Contributions and Ownership: Only employers can contribute to a SEP IRA, but employees fully own their accounts. As a business owner, you must contribute the same percentage of salary for each eligible employee as you do for yourself.

You cannot make catch-up contributions to a SEP IRA.

Written Agreement: If you’re the employer, you must provide a written plan to your employees. This plan should include the employer’s name and a clear formula for how allocations are calculated. It must be signed by an authorized person.

Non-deductible IRA

A non-deductible IRA is a retirement account to which you contribute after-tax dollars. In other words, you don’t deduct contributions from your taxable income as with a traditional IRA. You’re able to grow your money tax-free for retirement until gains are withdrawn.

The IRS limits some individuals from making tax-deductible contributions to a traditional IRA based on their income, and whether they have a retirement plan through their workplace. That’s where a non-deductible IRA comes in.

Your after-tax contributions to the IRA and any capital gains and dividends your contributions produce will grow tax-deferred. When you begin taking distributions during retirement, the portion of withdrawal representing non-deductible contributions will be tax-free. You’ll only pay tax on earnings and gains.

Contribution limits: Non-deductible contributions must comply with the same contribution limits set by the IRS.

Complex record-keeping: If you mix deductible and non-deductible contributions in your IRA, it can be challenging to separate the two, leading to confusion and potentially paying more taxes than necessary.

SIMPLE IRA 

A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a retirement plan for small companies (with 100 or fewer employees) and self-employed individuals. Both employers and employees can contribute to a SIMPLE IRA.

Contributions: Employees contribute by having part of their salary paid directly into their SIMPLE IRA.

Contribution limits: For 2024, employees can contribute up to $16,000 to a SIMPLE IRA ($19,500 if the employee is 50 or older), which is much higher than the limit for a traditional IRA. The employer must match the contribution up to 3% of the employee’s income or contribute a fixed 2% of the employee’s salary.

Choice of financial institutions: Employers can choose the financial institution for holding employees’ IRAs or let employees pick their own.

Rollover IRA

Rollover IRAs allow investors to transfer funds from an old employer-sponsored retirement account, such as a 401(k), into a traditional IRA. With this type of IRA, individuals can maintain their money’s tax-deferred status even when they leave an employer.

If they have a 401(k) with an employer they no longer work for, they might want to create a rollover IRA. Individuals with rollover IRAs can keep their other investment vehicles, including stocks and bonds.

Direct transfer: You can directly rollover IRA contributions into another account without paying the 20% withholding tax on the retirement plan distribution. There are exceptions to this rule, including non-qualified plans, loans, and required minimum distributions (RMDs).

To open a Rollover IRA, you typically need to request your employer’s plan administrator complete a direct transfer of funds from your old account.

Transfer to a Roth IRA: You can also roll over funds to a Roth IRA, but you must pay taxes since a Roth IRA uses after-tax funds. However, if previously you had a Roth 401(k) through your employer, you could roll the funds into a Roth IRA with no penalty.

Backdoor Roth IRA

A backdoor Roth IRA is a rollover IRA that allows account holders to transfer funds from a traditional IRA to a Roth IRA despite having a higher income than the IRS limit.

Those who want to open a typical Roth IRA but are disqualified because of IRS income limits can open a backdoor Roth IRA instead. This is not an official type of IRA but rather an informal name for a complicated method high-income taxpayers use to create a permanently tax-free Roth IRA.

To fund a backdoor Roth IRA, account holders must deposit funds from a traditional IRA into a Roth IRA within 60 days. This strategy allows higher-income people to grow their funds tax-free in a Roth IRA.

Income phase-out ranges: The IRS updates income limits each year for those eligible to contribute directly to a Roth IRA. However, individuals who exceed these limits can still contribute through a strategy known as a Backdoor Roth IRA, which allows high-income earners to bypass the income restrictions.

Tax requirements: Since Roth IRAs also use after-tax money, someone opening a backdoor Roth IRA would need to pay income tax on the funds in the year they transfer them from the traditional IRA to the Roth account.

Spousal IRA

The IRS requires taxable compensation to open and fund an IRA. However, married individuals filing jointly may be able to open an IRA even if they do not receive taxable compensation during the year. This type of IRA is called a spousal IRA.

A spousal IRA can be a traditional or a Roth IRA.

Contribution limitations: The Kay Bailey Hutchison Spousal IRA limit prevents contributions to a spousal IRA greater than $7,000—or $8,000 if the individual is 50 or older. Depending on their age, the total limit a couple can contribute to both IRAs can be between $14,000 and $16,000.

Qualifications: To open a spousal IRA, the working spouse must make enough income to contribute to both IRAs and qualify for the type of account.

Fund ownership: Although the working spouse contributes to the spousal IRA, the funds belong to the nonworking spouse, whose name is on the account. The account owner doesn’t change, regardless of who funds the account.

Inherited IRA

Individuals who open an IRA can name a beneficiary, who will receive the account upon the account owner’s death. This type of IRA is an inherited IRA, and anyone can be the account’s beneficiary, from a spouse or a child to an estate or trust.

An inherited IRA may be any type of IRA account. To receive the funds from an inherited IRA, the beneficiary typically has to transfer them to a new IRA in their name.

Spouse or non-spouse beneficiary: The IRS has different rules for beneficiaries depending on their relationship to the original account owner.

If a spouse inherits an IRA, they have several options for how to treat the account. They may treat the account as their own, roll it into another account, or treat themselves as the beneficiary. 

If a non-spouse inherits an IRA, they cannot make contributions or roll the funds over.

Inherited Roth IRAs: Beneficiaries are generally required to fully distribute the entire value of an inherited Roth IRA within five years of the original account holder’s death, although certain exceptions may apply.

Choosing the Right IRA for You

A suitable IRA for your financial situation depends on several factors, including income and tax filing status. The comparison below will help you determine which is suitable for your situation.

Tax bracket: Your current and expected future tax bracket plays a key role in deciding between IRAs.

Retirement age: Traditional IRAs offer tax benefits upon withdrawal, potentially aligning with lower tax brackets in retirement

Income tax situation: Traditional IRAs can lower current tax bills for those in high tax brackets

Investment goals: Consider risk tolerance and investment options offered by different IRAs. Traditional IRAs may offer a broader range of investment options, such as individual stocks, bonds, and mutual funds, as they are often offered by a wider variety of financial institutions and are not limited by income eligibility restrictions like Roth IRAs.

Find the Best Investment with 1031 Crowdfunding

When it comes to saving for your future, one place to start is figuring out which Individual Retirement Account (IRA) best fits your needs. 

IRAs are often well-suited for long-term investments, offering tax advantages that can help grow your savings over time. However, it’s important to understand the differences and choose the option that best fits your needs. 1031 Crowdfunding’s online marketplace provides a seamless way to use your IRA to invest in alternatives. Our seasoned management team, with extensive real estate expertise, is ready to guide you through every step of the investment process. 

Register today to create an investor account to get your retirement savings moving.

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