Types of IRA: What They Are and How to Choose

A good retirement plan is necessary for anyone who wants to enjoy a comfortable retirement. This includes preparing your retirement savings as early as you can.

Consider setting up an individual retirement account (IRA) for your retirement. With an IRA, you can grow your money over time and enjoy certain tax benefits.

Keep reading to learn more about the different types of IRA accounts.

Understanding IRAs

Before we dive into specific accounts like traditional and Roth IRAs, let’s start with the foundations.

Definition and Purpose of IRAs

An individual retirement account (IRA) is a tax-advantaged investment account for income earners. Generally, anyone with an earned income from a job or employment can open an IRA.

If you have an IRA, you can invest in different financial products, such as stocks, bonds, and mutual funds.

This means you can turn your money into investment earnings and gain tax advantages with IRAs.

Role of IRAs in Retirement Planning

IRAs help you achieve more financial security once you reach retirement age. They are a useful alternative for income earners who are not covered by a pension plan.

Think of the funds you put into your IRA as your retirement savings in the future.

You invest a percentage of your earned income now and reap the benefits later.

Eligibility Criteria for Opening an IRA

There is no age limit to setting up an IRA. You can own traditional and Roth IRAs as long as you have taxable compensation.

Even if you have a workplace retirement plan or 401(k), you can still apply for other types of IRA accounts.

What’s important to note is that different IRAs come with different requirements.

Common Terms Associated with IRAs

As you navigate this article, you’ll encounter some words repeated several times.

These are terms often associated with IRAs.

We’ve listed some of the most common ones for your reference.

Individual Retirement Accounts (IRAs): Long-term retirement accounts with tax benefits
Traditional IRAs: IRA contributions may be tax-deductible (mostly pre-tax dollars)
Roth IRAs: IRA contributions are not tax-deductible (mostly after-tax dollars)
401 (k) Plan: Workplace retirement plan offered by employers
Contributions: Funds invested in IRAs
Distributions: Funds withdrawn from IRAs
Required Minimum Distributions (RMDs): Minimum amount account owners are required to withdraw every year from their IRAs

Now that you have the basics down, let’s take a closer look at the various types of IRAs.

Diverse Types of IRAs: An Overview

Here are ten types of individual retirement accounts (IRAs) with a brief overview of each.

Traditional IRA

A traditional IRA is the most classic IRA. Anyone with earned income is eligible to open this type of retirement account.

You can contribute after-tax dollars or pre-tax dollars to a traditional IRA. But usually, your traditional IRA contributions are made with pre-tax dollars and may be tax-deductible.

If qualified, you can reduce your taxable income for the given year. Your income and tax filing status will serve as the basis for claiming any deductions.

Additionally, your money grows tax-deferred, while your withdrawals in retirement are taxable. Your earnings are taxed based on your ordinary income tax rate for that year.

Traditional IRAs are a good choice if you expect to move to a lower tax bracket after retiring.

Roth IRA

Next to traditional IRAs are Roth IRAs. To own this type of retirement account, your income level will be the basis for eligibility.

Contrary to traditional IRA contributions, you contribute after-tax dollars to a Roth IRA. Since it’s already your post-tax income, you’re not eligible for tax-deductible contributions.

In a Roth IRA, you can keep your money in your account for as long as you like. Even better is that your Roth IRA withdrawals in retirement are completely tax-free.

If you expect to be in a higher tax bracket once you hit retirement age, then a Roth IRA is ideal.

SEP IRA

Another IRA on our list is the SEP IRA, or Simplified Employee Pension. A SEP IRA is for employers and self-employed individuals. This includes freelancers and small business owners.

Small business owners usually set up a simplified employee pension for their employees. Only business owners can make employer contributions to a SEP IRA. Their employees cannot do so.

Furthermore, a SEP IRA is a type of traditional IRA with tax-deferred benefits. Your earnings are tax-free, but your distributions are subject to tax.

SIMPLE IRA

Another type of IRA is the SIMPLE IRA, or Savings Incentive Match Plan for Employees. Like a SEP IRA, a SIMPLE IRA is for employers and self-employed individuals. This also includes freelancers and small business owners.

This time around, a SIMPLE IRA allows employee contributions. Employers and employees can contribute to a savings incentive match plan for employees.

An employer is required to match an employee’s IRA contribution. This is usually up to 3% of the eligible employee’s compensation.

An alternative is nonelective contributions. This allows employers to make contributions of 2% of each eligible employee’s compensation.

Nondeductible IRA

A non-deductible IRA is a traditional IRA for people with income limitations.

This type of retirement account is typically funded with after-tax dollars. This IRA caters to those who have restrictions on how much money they can set aside for retirement.

This allows your IRA contribution to have tax-deferred growth benefits. But compared to your normal traditional IRAs, you can’t claim a tax deduction.

Spousal IRA

As a general criterion, a person must have an earned income to contribute to an IRA. But there is a special exception for married couples.

A spousal IRA allows the working spouse to fund the account on behalf of the non-working spouse.

The same applies if one of them has a very low income. It follows the annual contribution limits for traditional and Roth IRAs.

This is possible as long as the contributions come from either spouse’s earnings. The IRA account must also be under the non-working spouse’s name.

Self-Directed IRA

If you’re a savvy investor, choosing top self-directed IRA options may be your best bet.

A self-directed IRA (SDIRA) gives you more freedom over your investments.

Be it a traditional or Roth IRA, you can own unique and diverse assets through an SDIRA. This includes investments in real estate, private equity, tax liens, gold and other precious metals, and more.

Rollover IRA

A rollover IRA is an IRA funded by another retirement plan. This is often composed of rolled-over funds from an old employee-sponsored 401(k) plan.

If you take an in-depth look at rollover IRAs, you’ll find that there is no limit to how much money you can rollover. Some exceptions include the required minimum distributions and loans.

A rollover IRA follows the same rules as a traditional IRA.

Inherited IRA

An inherited IRA is an IRA funded from the retirement plan of a deceased owner. As this is an account you open as a beneficiary, it is also called a beneficiary IRA.

The detailed rules for inherited IRAs state that you cannot make contributions. You can only make withdrawals.

Remember that as a beneficiary, you need to liquidate the account within ten years of the death of the original owner.

Backdoor IRA

A backdoor IRA is a strategy used by high-income earners, involving converting their traditional IRA into a Roth IRA. This is to overcome the income limits required by Roth IRA accounts.

An important thing to highlight is that a backdoor IRA is not a tax dodge. You can still incur taxes when you transfer your funds from a traditional IRA to a Roth IRA.

Delving into Each IRA Type

Whether it’s a traditional or Roth IRA, different IRAs suit different investors.

Let’s dive into the different types of IRAs.

Unique Features and Benefits

Here’s a list of unique features and benefits for each IRA.

Traditional IRA

Tax deductions on contributions
No income limits

Roth IRA

Tax-free qualified distributions
No mandatory withdrawals

SEP-IRA

Higher contribution limits
Tax-free earnings

SIMPLE IRA

Tax credit for employers
No vesting

Nondeductible IRA

Non-deductible contributions
Tax-free gains

Spousal IRA

Shared contributions between spouses
Shared tax burdens

Self-Directed IRA

More investment options
More flexibility and control of assets

Rollover IRA

Lower fees
Potential tax-deferred status

Inherited IRA

Early withdrawals without penalty
For beneficiaries

Backdoor IRA

Significant tax savings
No required minimum distributions

Tax Implications

IRAs have many tax benefits. This includes tax-deferred growth, earned income tax credits, tax exemptions, and more. Thus, it’s important to know the tax implications they have.

In traditional IRAs, your contributions may be subject to tax deductions. This happens from case to case. You have to factor out your income level, filing status, and retirement plan coverage. As for your distributions, they are subject to tax.

In Roth IRAs, your contributions do not have tax deductions. Instead, your qualified distributions are tax-free. You can withdraw your contributions from your account without incurring taxes.

Generally, it’s better to withdraw your funds when you reach the age of 59½, so it’s tax-free.

But if you want to, it’s also possible to make withdrawals before retirement. The only catch is that these advanced withdrawals may be subject to penalties.

For traditional and Roth IRAs, if you withdraw your earnings before age 59½, you’ll have to pay taxes and a 10% penalty.

Contribution Caps and Deadlines

Here are the annual contribution limits for each type of IRA. Note that the listed contribution limits are for 2024.

Traditional IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
Roth IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
SEP IRA: The lesser of 25% of employee compensation or $69,000
SIMPLE IRA: $16,000 (with a catch-up contribution of $3,500 for age 50 or older)
Nondeductible IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
Spousal IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
Self-Directed IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
Rollover IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)
Inherited IRA: Inherited IRA owners cannot make contributions.
Backdoor IRA: $7,000 (with a catch-up contribution of $1,000 for age 50 or older)

Besides the usual IRA contribution limits, there are also catch-up contributions. They refer to the allowable additional contributions for people who are age 50 or older.

By rule of thumb, you can make your IRA contributions until the tax day of the year prior. In 2024, you can make your contributions for your 2023 tax year limit until April 15, 2024.

Withdrawal Norms and Penalties

By principle, when you’re 59½ or older, the withdrawals you make from any IRA will not incur penalties. These withdrawals are also called normal withdrawals or normal distributions.

Before you get confused, normal distributions are different from required minimum distributions (RMDs).

An RMD refers to the mandatory withdrawal amount a person makes every year, starting at the age of 73. Between traditional and Roth IRAs, only traditional IRAs have RMDs. On the other side, a normal distribution refers to the withdrawals a person makes between ages 59½ and 73.

Distributions for Traditional and Roth IRAs

In traditional and Roth IRAs, distributions between ages 59½ and 73 are penalty-free. However, specific tax rules may apply to withdrawals.

For traditional IRAs, your withdrawals are taxable income. You are usually taxed at your ordinary income tax rate for that year. Additionally, they may be subject to federal and state taxes. Rollover IRAs, SEP IRAs, and SIMPLE IRAs follow the same rules as traditional IRAs.

For Roth IRAs, your withdrawals are tax-free as long as you’ve had your account for at least 5 years. If you decide to withdraw before the 5-year limit, your earnings are subject to tax. At this point withdrawals may also be subject to taxes.

Early Withdrawals

In the event of withdrawals before age 59½, there’s a separate set of conditions for them. These generally apply to both traditional and Roth IRAs.

The Internal Revenue Service (IRS) labels them as early withdrawals. Any distributions before age 59½ are subject to federal and state taxes. You are likely to incur a 10% tax penalty as well.

Compared to your regular IRAs, SIMPLE IRAs have a higher penalty on top of the usual ones. If you withdraw from a SIMPLE IRA within 2 years of your first deposit, you may be subject to another 25% penalty fee.

There are a few exceptions to avoid the 10% and 25% tax penalties. Here are some of them:

Withdrawals for a qualified education expense
Withdrawals for health insurance (only for the unemployed)
Withdrawal for birth or adoption expenses
Withdrawals after disability
Withdrawals for first-time home purchases (up to $10,000)

Rollover Rules

For starters, you are allowed only one rollover of funds from one IRA to another in a year. Even if you have multiple IRAs, you will have to wait.

In Rollover IRAs, there’s also a thing called “The 60-Day Rule.” This means you have 60 days to roll over your funds from one retirement account to another.

If you miss the deadline, your contributions and account earnings are subject to tax. An additional 10% penalty may also apply. However, the Internal Revenue Service may waive this rule for events out of your control.

Comparing Different IRA Options

To understand more about the different IRAs, here’s a brief comparison.

Traditional IRA vs. Roth IRA

Let’s briefly compare Roth and traditional IRA against each other. The main difference between these two types of IRAs is their tax breaks.

In a traditional IRA, your traditional IRA contributions are tax-deductible. However, you pay taxes on your withdrawals during retirement.

In a Roth IRA, your Roth IRA contributions are not tax-deductible. But during retirement, you get tax-free withdrawals.

If you think you will move from a higher tax bracket to a lower one after retiring, go for traditional IRAs. If you think the reverse situation will occur, opt for Roth IRAs instead.

SEP IRA vs. SIMPLE IRA

SEP IRA and SIMPLE IRAs cater to self-employed individuals and small business owners. A key difference is who can contribute to the account.

In SEP IRA, only employers can place contributions into the account. However, for a SIMPLE IRA, employees can also put money into the account.

Traditional IRA vs. Rollover IRA

Traditional IRAs and rollover IRAs are almost the same. But in a rollover IRA, funds come from an employer-sponsored retirement plan or 401(k). This is reported to the Internal Revenue Service and may be subject to taxes.

Roth IRA vs. Backdoor IRA

In a Roth IRA, you can enjoy tax-free withdrawals in retirement. A backdoor IRA is a strategy to allow high-income earners to set up a Roth IRA. This is possible despite the contribution limit for a Roth IRA.

IRA vs. Other Retirement Accounts

You might be wondering how IRAs differ from a 401(k) and other retirement plans.

A quick comparison in the next section will be helpful in understanding IRA accounts and how they differ from other retirement savings options.

IRA vs. 401(k): A Comparative Analysis

Both an IRA and a 401(k) plan are retirement savings accounts with tax advantages. Only employers offer 401(k) plans.
An IRA has more investment options. A 401(k) plan has a higher annual contribution limit.
If you’re an employee, you can contribute up to $23,000 to your 401(k) account. For IRAs, the contribution limit is $7,000 ($8,000 for age 50 or older). This is the ceiling for 2024, as declared by the Internal Revenue Service.
In an IRA, you get to choose how much money you put into your account, as long as it’s within the annual threshold.
In a 401(k) plan, you set aside a percentage of your employee compensation and invest it in this retirement plan.
Employers can also make matching contributions in a 401(k).

IRA vs. Pension: Key Differences and Similarities

An IRA and a pension are both retirement accounts, but they still have some differences.
Like a 401(k), a pension is a type of employer-sponsored retirement plan. Both the employer and employee can contribute to a pension. While in an IRA, you are in control of your contributions as an individual.

IRA vs. Social Security: Understanding the Distinctions

An IRA is a type of investment savings account. Social Security is a type of government insurance program.
An IRA acts as a retirement savings plan. Social Security offers more benefits to qualified citizens in the U.S.
Social Security benefits include retirement benefits, disability income, and medical insurance.

Making the Right IRA Choice

By now, you should understand how beneficial it is to own IRA accounts. With so many types of IRAs to choose from, it can get a little overwhelming.

Read this section if you need help choosing between the different types of IRA.

Factors to Consider when Choosing an IRA

Here are a few factors to consider when choosing an IRA.

Research the types of IRAs. There are various types of IRAs. It’s important to know your options like the back of your hand. Ask yourself whether the type of IRA you’re considering aligns with your financial goals.
Learn about tax advantages. Different types of IRAs have at least one tax advantage, so settle your priorities. What tax savings opportunities are you looking for? Does the IRA you’re looking at offer the tax perks you want? What are the limitations?
Check for qualified financial institutions. Banks and credit unions are convenient places where you can set up an IRA. There are other financial institutions with even better services. Do a background check on your alternatives.
Consult a financial expert. Seeking financial advice from professionals is a great way to confirm your research. Ask around among people you know and ensure the person you reach out to is credible.

Importance of Financial Advisors in IRA Selection

A financial advisor plays a vital role in financial planning. This is their area of expertise.

In IRA selection, financial advisors can help you in many ways.

They can assess your goals for retirement with you.
They can help you create long-term strategies for your retirement plan.
They can manage your retirement savings for you and boost them through investments.
They can provide financial advice about investment vehicles you can leverage.

The Role of Tax Professionals in IRA Decisions

IRAs involve a lot of tax activities under the thorough supervision of authorities.

This makes tax professionals an indispensable part of all IRA decisions.

They can identify ways to minimize your tax liabilities.
They can develop tax-efficient strategies to align with your retirement goals.
They can guide you to remain compliant with all tax requirements.
They can provide tax-related expertise for your decisions about your IRA accounts.

Setting Up an IRA

After considering this information, it’s time for you to know how to set up an IRA.

Steps to Open an IRA

Opening an IRA account is easy and hassle-free. Below are four simple steps on how you can do it.

Check your eligibility. Are you an income earner? How much is your earned income? These are two important factors you have to consider before you proceed with your IRA.
Choose your financial institution. Once you confirm your eligibility, research where to best open up your IRA account. It can be with a bank or an online brokerage.
Decide on the type of IRA. If you want to open a traditional or Roth IRA, make sure to know about the rules governing them. You may want to consult the Internal Revenue Service website too.
Open an account. This is usually done online, but you can also visit a bank or other providers. Check if the place has authorization from the Internal Revenue Service.

Choosing the Right Financial Institution

If you’ve finally decided to open an IRA, make sure to choose a credible financial institution. These can include banks, credit unions, brokerage firms, insurance agencies, and investment companies.

Here’s a quick checklist of criteria to help you decide where to set up your IRA.

Check if the provider offers diverse investment options. Take your time to study the available assets for future investment opportunities.
Check if the provider has good customer service. You’re better off with a provider you can reach out to 24/7 or as soon as possible
Check if the provider has low account fees and costs. Compare it to other providers you’re considering.
Check if the provider has an IRA consolidation option. Consider this feature if you have or plan to open several IRAs.

Role of IRA Custodians

IRA custodians are financial providers authorized and certified by the Internal Revenue Service.

Their role is to manage an account holder’s IRA to ensure proper compliance with government regulations.

Managing Your IRA Investments

Whether it’s for a traditional IRA or a Roth IRA, learning how to manage your IRA investments is important.

Here are four tips on how to manage them effectively.

Stay alert and ready. Set aside regular funds from your income or salary for your IRA. Assess your ability to tolerate risks.
Diversify your asset portfolio. Research your investment options. Consider holding stocks through mutual funds or exchange-traded funds. Allocate your money across different investment vehicles.
Be patient. Returns from investments take time. Try not to make withdrawals unless necessary. Let your money compound as you wait.
Keep an open mind. Consult a financial expert if you must.

Frequently Asked Questions

Learn more about different IRA types here.

What Is the Difference Between a Traditional IRA and a Roth IRA?

The difference between a traditional IRA and a Roth IRA is their tax break.

In a traditional IRA, you get your tax break up front. Your traditional IRA contributions are deductible, earnings are tax-deferred, and withdrawals are taxable. Your earnings are taxed based on your tax rate for that year.

In a Roth IRA, you get your tax break later. Remember that your Roth IRA contributions are not tax-deductible.

With this type of account, your money grows and can be withdrawn tax-free. Investors who expect to move up to a higher tax bracket during retirement would typically prefer a Roth IRA.

Can I Have More Than One Type of IRA?

Yes, you can, even if you have a 401(k). There’s a wide range of IRAs available. There are IRAs for business and self-employed individuals too. It’s understandable if you want to own more than one.

However, there’s a limit to how much contribution you can make. It cannot exceed the contribution cap across all your accounts in a given year.

The contribution limit for IRAs applies to all accounts cumulatively and is not separated by account type.

What Are the Tax Implications of Withdrawing From an IRA Before Retirement Age?

If you withdraw from an IRA before the age of 59½, the amount may be subject to tax and a 10% penalty fee.

How Does a Rollover IRA Work?

A rollover IRA is an account used to transfer funds from one retirement account to another.

What Is the Maximum Amount I Can Contribute to an IRA in a Year?

The ceiling amount you can contribute to an individual retirement account in a year is $7,000. It has catch-up contributions of $1,000 for people who are 50 or older.

Conclusion

An individual retirement account (IRA) is a long-term savings account with tax advantages. It can help you grow your money through investment earnings.

Choosing from the types of IRA can be tricky, so it would be wise to conduct your research thoroughly.

We recommend consulting with a financial advisor for your retirement planning needs. Once you’ve done all that, you’re one step closer to a worry-free retirement.