There are four different types of IRAs, the 2 most common being a Traditional IRA and a Roth IRA. All IRAs have tax-advangtages that make them an efficient way to save, but here’s what makes them different 👇
Interested in pre-tax (potentially tax-deductible) contributions and tax-deferred earnings? Consider a Traditional IRA structure. Traditional IRA features include
- Fully or partially deductible contributions (up to the annual limit), depending on the taxpayer’s circumstances
- Taxes generally deferred until qualified distributions begin
- Distributions allowed penalty-free beginning at age 59½
- Required minimum distributions (RMDs) after the date that you turn 70½ (72 if you reach the age of 70 ½ after December 31, 2019)
- Open eligibility (anyone with earned income can contribute)
However, if you’re a business owner or are self-employed, you might consider a SEP or SIMPLE IRA. Like Traditional IRAs, both plans allow pre-tax contributions and have the same distribution rules. Oftentimes, it’s either the size of the business or the preferred contribution method that helps one decide which is right for his or her situation.
Due to its after-tax structure, the Roth IRA is the “odd man out” of the group. It’s the only type of the four to offer a post-tax structure. So, if you’re interested in post-tax contributions and tax-free earnings, then consider a Roth IRA structure. Roth IRA features include
- Non-deductible contributions (up to the annual limit)
- Tax-free earnings
- Qualified distributions are tax-free
- No RMDs, except upon the death of the account holder
- Income-eligibility restrictions
Click here to compare Roth IRAs to Traditional IRAs.
Note that any Traditional, SEP, or SIMPLE IRA may be converted to a Roth IRA. The account holder would take a distribution from the pre-tax account, and he or she would need to pay income taxes (without any penalties, however) on the distribution before rolling over to the Roth. Kingdom Trust has an easy-to-use Conversion Instructions form for this purpose.
SEP IRAs allow employers to make tax-deductible contributions for participating employees. SEPs are available to any size business and are widely used by small family businesses and the self-employed. With the self-employed, the business owner is considered the employee. SEP IRAs have a few eligibility limits.
The pre-tax contributions for any given year may not exceed 25% of earned income, up to certain annual limits. The employer may choose how much he or she contributes each year. In fact, the employer can choose not to fund the plan depending on the business’ financial situation. Also, the contribution must be the same for each participating employee.
Similar to SEPs, SIMPLE IRAs allow employers to make tax-deductible contributions for participating employees. However, the SIMPLE is generally available to small businesses with 100 employees or less. SIMPLE IRAs also have a few eligibility limits, and the employer cannot have any other retirement plan.
With SIMPLE IRAs, employees may contribute a percentage of their pre-tax income into their specific IRAs, up to the annual limit. The IRA also receives contributions from the employer. Those required employer contributions may be a matching contribution up to 3% or a 2% “nonelective” contribution.
With both SEP and SIMPLE IRAs, the plan is established by the employer with an IRA established for each participating employee. Both plans allow contribution flexibility and may help reduce business taxes. Each plan also follows Traditional IRA distribution rules, including RMDs.
Also, the employee is 100% vested in all SEP or SIMPLE IRA funds. Both plans have lower startup and operating costs and are easier to set up than other qualified employer plans, which makes them very attractive to small businesses. In fact, you only have one form (a 5305-SEP and a 5304-SIMPLE or 5305-SIMPLE) versus significantly more paperwork for other employer plans. Check out IRS Publication 560 for more on retirement plans for small businesses.
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