Planning for a successful retirement may seem complex, but it doesn’t have to be.
As you prepare for the future, it can be helpful to take time to understand the different tax advantaged ways you may be able save for retirement. For example, maximizing your savings in a workplace retirement plan, such as a 401k or 403b, can be a great way to save for retirement and enjoy certain tax advantages.
But if you don’t have access to a workplace retirement plan – and even if you do – you may be still able to take advantage of an Individual Retirement Account (IRA). In fact, anyone with earned income can contribute to an IRA. It’s important to understand the different types of IRAs, including the contribution limits and the tax advantages of each type, which are largely based on your income and whether you or your spouse have access to a workplace retirement plan.
The two main types of IRAs – Traditional and Roth
The most commonly used IRA types are Traditional IRAs and Roth IRAs. The primary difference between them is the way they are taxed. Your Roth IRA contributions are not tax deductible, but your qualified distributions will be tax-free. The opposite is typically true for Traditional IRAs. Here’s more on how each works.
Traditional IRA
The Traditional IRA is the most common type of IRA – typically, all or some of your contributions are tax deductible, depending on your income level, and any growth in your account is tax-deferred. This means you can reduce your taxable income for the year your contribution is made, and you don’t pay taxes on the money you’ve contributed - or on any growth in the account - until you withdraw the funds, which is typically when you’re retired (withdrawals prior to age 59 ½ are subject to an additional 10% federal tax). For many retirees, that could mean paying a lower tax rate, if their income tax bracket is lower during retirement than when they were working.
A traditional IRA might be a good option if you’d like to reduce your taxable income now and if you think you will be in a lower tax bracket when you’re retired. While anyone who has earned income can contribute to an IRA, the amount you can deduct on your taxes phases out at higher income levels.
Roth IRA
Roth IRAs differ from Traditional IRAs in terms of when you may obtain tax benefits. Roth IRA contributions must be made with after-tax dollars, that is, money you have already paid taxes on. The key advantage of a Roth IRA is that when you take qualified distributions, the money is tax-free. Since you have already paid income tax on the money you contribute, you do not have to pay income tax on qualified distributions. A distribution is considered qualified if you’re at least 59 ½ or older and the account has been held for five years. Other conditions, such as a first-time home purchase, disability or death can also allow for qualified distributions.
You may want a Roth IRA if you anticipate being in a higher tax bracket in retirement, as contributions are made with after-tax dollars. It’s important to note that if you are a higher income earner, you may not be eligible to contribute to a Roth IRA – for 2023, the income limit is less than $153,000 for single tax filers and less than $228,000 for those who are married and filing jointly.
For 2023, the total aggregate contributions you can make each year to your traditional IRAs and Roth IRAs is $6,500, or $7,500 if you're age 50 or older.
Other types of Individual Retirement Accounts
Simplified Employee Pension (SEP) IRA
For self-employed and small business owners, SEP-IRAs offer an alternative to 401(k) plans. With a SEP-IRA, the employer makes contributions on behalf of the employee, which in 2023 is up to 25% of their salary or $66,000, whichever is less.
Contributions are tax deductible for businesses and, and as long as the contribution is not an excess contribution, are not treated as taxable compensation to employees. Like a traditional IRA, the contributions and earnings are tax deferred, and withdrawals are taxed as ordinary income.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
SIMPLE IRAs are for employees of small businesses (up to 100 employees). In these plans, employees can choose to defer income by contributing to the SIMPLE IRA, like a 401(k) or 403(b), and the employer is required to make either a matching or nonelective contribution. For nonelective contributions, the employer must contribute for all employees, even if the employee doesn’t participate in the plan. For matching contributions, employers match up to 3% of employee contributions. For 2023, the contribution limit for employees is $15,500, with an additional catch-up contribution of $3,500 for employees aged 50 or older.
Spousal IRA
While you typically need to have earned income to contribute to an IRA, the spousal IRA is an option for single-income couples who file jointly. The income-earning spouse can fund the IRA of the non-income earning spouse, and the account can be either a Traditional or Roth IRA. Spousal IRAs have the same annual contribution limits as other IRAs – for 2023, the limit is $6,500, or $7,500 if age 50 or older.
Rollover IRA
Rollover IRAs are created by rolling over funds from an employer-sponsored retirement plan, such as a 403(b) or 401(k), to maintain tax-deferred growth of your existing retirement assets. A Rollover IRA can also help consolidate retirement funds from several sources, which can simplify your money management. That said, rollovers may not make sense for all individuals. It can make sense to keep your current employer-plan if it offers lower expenses, additional services, or access to loans.
Inherited IRA
When you are the beneficiary of another person’s Individual Retirement Account, you have an inherited IRA. The rules and deadlines related to these accounts can be a little tricky – if the deceased person was taking distributions, you must continue to take the distribution for that calendar year. You also may be required to draw down the entire account balance within 10 years. Special rules may apply, so it’s good to speak with a professional about how you should handle your inherited IRA.
Talk with a financial professional
IRAs can be a valuable avenue for saving and establishing income in retirement. Although the contribution methods and thresholds may vary among these common IRA types, they all aim to enhance your retirement security.
It’s important to understand the rules for each type of IRA, including how contribution limits can change from year to year, when you are required to begin taking withdrawals, and the impact of taking early withdrawals. It can make sense, when deciding which IRA is right for you, to speak with a trusted financial professional.