Saving for retirement is often a crucial part of a long-term investment plan. The individual retirement account (IRA) is a widespread method people use for investing in their retirement, with nearly 48 million households and over 60 million individual taxpayers in the United States owning at least one IRA. IRAs are tax-advantaged accounts that allow account holders to invest funds for tax-free or tax-deferred growth.
IRA owners can choose to invest their funds in different assets to potentially grow their wealth. Investing in assets involves some degree of risk, which individuals can select based on their preferences. However, this retirement account can also potentially grow income and an investor’s net worth, offering numerous opportunities for contributing to other investment vehicles. The types of IRA accounts an investor opens impact their wealth growth and tax responsibility.
What Is an IRA?
An IRA is an account an individual can set up and use to compound retirement funds. The advantage of an IRA is that, depending on the type of account, the Internal Revenue Service (IRS) usually only taxes funds once, either before the owner makes a contribution or when they take a distribution. Early withdrawals can also trigger taxes. Because the funds in an IRA earn tax-free interest and are not a tax liability to the account holder, the money can grow faster than it would in a taxable account.
Depending on the type of investment chosen, some IRAs accrue interest based on the funds the owner contributes, although contribution limits apply. Account owners can also use IRA funds to make passive income through other investment opportunities.
Types of IRAs
You have several options when determining which IRA is right for you. There are two primary ways an IRA works — with pre-tax or after-tax funds. Within these two categories are 10 types of individual retirement accounts.
1. Traditional IRA
One of the most popular types of IRAs is the traditional IRA. Almost all taxpayers can establish IRAs, but high-income individuals are more likely to have an account. Funds in a traditional IRA are generally fully or partially tax-deductible and are taxed when the owner takes a distribution, typically starting at age 59 ½. The account holder’s investments grow tax-deferred until withdrawal when the IRS charges income tax based on the individual’s tax bracket.
Many investors choose a traditional IRA if they expect their income in retirement will be lower than when they opened the account. Investors might also prefer to take the tax deduction immediately, such as when they are trying to lower their tax liability for the current year. A traditional IRA might be the best option in any of these scenarios.
Investors can open a traditional IRA with their bank, stockbroker, online brokerage, or other financial institution. The IRS rules for traditional IRAs include:
- Contribution and deduction limits: The IRS has annual contribution limits for all types of IRAs. The limit for those younger than 50 is $6,000, while people age 50 and over can contribute $7,000 yearly as a catch-up provision. In addition, investors can only deduct a portion of their contributions to a traditional IRA if their income meets the IRS’s modified adjustable gross income (AGI) limit for traditional IRAs.
- Early withdrawal penalties: An individual can withdraw from their traditional IRA without penalty at age 59 ½. Withdrawals taken before that age are usually subject to a 10% penalty and standard income taxes. Withdrawals are not penalized in certain situations, such as for educational expenses, a first-time home purchase, specific medical expenses, and birth or adoption costs.
- Required minimum distributions (RMDs): Once an account holder turns 72 years old, they must begin taking RMDs from their traditional IRA. If they fail to do so, they may incur a tax penalty of 50% of the required distribution amount.
2. Roth IRA
The tax advantage with a Roth IRA comes at withdrawal rather than contribution. Investors make contributions with after-tax funds and can potentially use the money tax-free later in retirement. Roth IRA contributions are not tax-deductible.
Those who expect to be in a higher income bracket at retirement than when they open their retirement account might choose a Roth IRA because qualified withdrawals are tax-free. Opening a Roth IRA requires setting up an account with a financial institution or investment company.
Those interested in Roth IRAs should be aware of their unique requirements:
- Contribution qualifications: You can contribute the total amount to a Roth IRA if you have taxable compensation, are married filing jointly, or are a qualified widow or widower and your AGI is less than the IRS limit.
- Contribution limits: The annual contribution limit is $6,000 for those younger than 50 and $7,000 for those 50 and above. The extra $1,000 per year is considered a “catch-up” contribution.
- Qualified distributions: Typically, you can withdraw contributions or earnings from your Roth IRA tax-free since you used after-tax dollars to fund the account. Accounts must be 5 years old or the owner must be 59 ½ to withdraw earnings without being taxed or penalized.
3. Self-Directed IRA
A self-directed IRA (SDIRA) is a traditional or Roth IRA containing asset types that are normally prohibited from a regular IRA. The IRS typically restricts investors from investing in life insurance or collectibles with their IRAs. However, an SDIRA can enable owners to acquire higher-risk assets like real estate, precious metals, commodities, private placements, partnerships, tax liens, and business franchises.
Opening a self-directed IRA is the same as opening other types of IRAs, except an investor may need to search more to find a specialized custodian or financial advisor who will hold the account. Some essential factors surrounding a self-directed IRA include:
- The necessity of a custodian: As with other types of IRAs, individuals interested in opening a self-directed IRA must have a custodian or trustee who agrees to the arrangement. A custodian could be a bank, credit union, or other financial institution. With self-directed IRAs, it might be more challenging or expensive for investors to find a custodian willing to take alternative assets like commodities and private placements.
- High returns and high risks: Those who want to open an SDIRA can potentially benefit from the higher diversification and yields. However, owners should also be aware of the potential risks involved. Any prohibited transactions can cost account holders highly, and custodians are not legally allowed to provide financial advice.
- Contribution limits and early withdrawal penalties: SDIRAs must comply with the contribution limits and early distribution penalties of a traditional or Roth IRA, whichever account holders decide to use.
4. SEP IRA
A simplified employee pension (SEP) IRA is specifically designed for business owners and those who are self-employed. Contributions to the account are tax-deductible, and the IRS taxes distributions as regular income.
Investors must own a business or file as self-employed to open this type of IRA. Business owners can contribute up to 25% of the employee’s compensation or $61,000, whichever is less.
Business owners interested in a SEP IRA must find a financial institution that will act as the trustee of the SEP IRAs. Individuals should be aware of the following rules regarding SEP IRAs:
- Qualification: Employees may receive a SEP IRA if they are at least 21 years old, earned $650 from the employer for 2021 and 2022, and have worked for them for at least three out of the past five years.
- Contribution and ownership: Only the employer contributes funds to a SEP IRA. However, ownership belongs entirely to the employee. Employers must contribute equally to all employees, regardless of their compensation. Employers must also contribute the same amount to their employees as to their own accounts. Catch-up contributions are not allowed.
- Written agreement: Employers must provide all employees with a formal written agreement concerning their benefits, requirements, and investment opportunities. This document must include the employer’s name and a definite allocation formula and be executed by the responsible official.
5. Nondeductible IRA
Nondeductible IRAs are nondeductible contributions to a traditional IRA. Account owners pay income taxes on contributions to nondeductible IRAs, and the funds are ineligible for tax deductions. However, deductible and nondeductible contributions are tax-free at withdrawal as long as they are at the contribution limit.
The IRS prevents some individuals from making tax-deductible contributions to a traditional or Roth IRA based on their income, filing status, and whether they have a retirement plan through their workplace. High earners may choose to make nondeductible contributions to their IRAs when they are otherwise disqualified from contributing to a traditional or Roth retirement account.
Individuals who make nondeductible contributions must abide by specific regulations:
- Contribution limits: Nondeductible contributions must comply with the same contribution limits set by the IRS.
- Tax-deferral for earnings and gains: Only the earnings from the nondeductible funds are taxed at withdrawal. Contributions are taxed upfront.
- Complex record-keeping: If an investor combines deductible and nondeductible contributions, it might be challenging to separate the two, making it easy to pay more taxes.
6. SIMPLE IRA
A Savings Incentive Match Plan for Employees IRA (SIMPLE IRA) enables businesses with 100 employees or less and the self-employed to contribute to employees’ retirement accounts. Both employers and employees can contribute to a SIMPLE IRA.
Employers with 100 or fewer employees can open the plan through a financial institution and make yearly disclosures to employees. An employer may choose a SIMPLE IRA for their employees because of the simplicity of the plan and low maintenance costs.
Individuals considering a SIMPLE IRA should consider these factors:
- Contributions: Employees with a SIMPLE IRA must make salary reduction contributions, meaning that the amount they contribute to their IRA comes from their salaries. Employees can contribute up to $13,500 to a SIMPLE IRA, which is significantly more than the limit for a traditional IRA. The employer must match the contribution up to 3% of the employee’s income or make nonelective contributions of 2% of the employee’s compensation.
- Choice of financial institutions: Employers can either select the financial institution holding employees’ IRAs or allow employees to choose the institution for their plan.
7. 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.
Individuals might want to create a rollover IRA if they had a 401(k) with an employer for whom they no longer work. Individuals with rollover IRAs can keep their other investment vehicles, including stocks and bonds.
Individuals considering a rollover IRA should be aware of several factors unique to these kinds of accounts:
- Direct transfer: Rolling IRA contributions directly into another account allows the owner to avoid paying a 20% tax on their retirement plan distribution. To open this kind of IRA, account owners typically request that their former employer’s plan administrator complete a direct transfer of funds from their old account.
- Transfer to a Roth IRA: Account owners can also roll over funds to a Roth IRA, but they must pay taxes since a Roth IRA uses after-tax funds. However, if the individual previously had a Roth 401(k) through their employer, they could roll the funds into a Roth IRA with no penalty.
8. Backdoor Roth IRA
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.
A backdoor Roth IRA is a type of 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.
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 those with higher incomes to grow their funds tax-free in a Roth IRA.
Individuals considering opening a backdoor Roth IRA should be aware of some IRS rules:
- Income phase-out ranges: The IRS recently released new income ranges for those who can contribute to a regular Roth IRA, so individuals should check whether they qualify before creating a backdoor Roth IRA.
- Tax requirements: Since Roth IRAs also use after-tax money, someone opening a backdoor Roth IRA would also need to pay income tax on the funds in the year they transfer them from the traditional IRA to the Roth account.
9. 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 Roth IRA. Couples can speak with their financial institution to open an account like this. Couples interested in opening a spousal IRA should know about a few regulations:
- Contribution limitations: The Kay Bailey Hutchison Spousal IRA limit prevents contributions to a spousal IRA greater than $6,000 — or $7,000 if the individual is 50 or older. The total limit a couple can contribute to both IRAs can be between $12,000 and $14,000.
- 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 is the person who contributes to the spousal IRA, the funds belong to the person whose name is on the account — the nonworking spouse. The account owner doesn’t change, regardless of who funds the account.
10. 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.
Inherited IRAs may be any type of IRA account. To receive the funds from an inherited IRA, the beneficiary typically has to transfer the funds to a new IRA in their name.
Before opening an inherited IRA, account owners should consider the following:
- 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 must take all distributions of interest from an inherited Roth IRA within five years after the original account holder’s death.
Which IRA Is Right for You?
The best kind of IRA for your situation depends on several factors, including income and tax filing status. Here are a few questions to ask yourself that can help you think about the type of IRA that would best suit your needs:
- Do you want a tax advantage at contribution or distribution?
- Is there anyone you want to benefit from my IRA, like a spouse or a child?
- If you are an employer, how many employees do you have and do you want to contribute to their IRAs?
- Do you already have an employer-sponsored retirement plan, and do you plan to change jobs?
Individuals may also consider opening multiple IRAs. You can have as many IRAs as you want, providing you qualify for and follow the rules for each. Here are some of the advantages of having multiple IRAs:
- More investment opportunities: Opening multiple IRAs gives investors more investment opportunities. For instance, someone with a self-directed IRA can use that account for higher-risk investments and keep standard investments in their traditional IRA.
- Greater flexibility in withdrawals: If an individual has a traditional IRA and a Roth IRA, they can take distributions from the Roth account — as long as it is 5 years old — without having to pay the early withdrawal penalty that the traditional IRA requires.
Disadvantages of owning multiple types of IRA accounts include:
- Contribution limits: Owners of multiple IRAs can only contribute up to the annual limit across all their accounts, so owning more accounts doesn’t mean an individual can contribute more.
Learn More About Smart Investments With 1031 Crowdfunding
IRAs may be a potentially valuable source of income for qualifying individuals, especially as they reach retirement age. With the many IRA types available, picking the right account for your situation requires careful consideration and evaluation of your financial goals.
At 1031 Crowdfunding, we help our clients invest in real estate to gain a consistent source of passive income and increase their net worth. We are a state-of-the-art online marketplace for 1031 exchange investments, facilitating various real estate investment strategies. Our knowledgeable management team has the experience to handle diverse real estate investment situations our clients might face.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.