Individual Retirement Accounts, known simply as IRA’s, can sometimes be confusing. There are traditional IRA, Roth IRA, SEP IRA, Simple IRA, and Self-Directed IRA accounts. In addition to these retirement accounts there are Coverdell Educational Savings Accounts that used to be called Educational IRA’s.
What Are IRA’s
Here are the basics you need to know. IRA’s are retirement savings/investment accounts that receive a favorable tax treatment to encourage people to save for retirement. People may choose to manage their own investments in an IRA but most use investment advisers that offer management services as well.
Almost any investment may be included in an individual investment account and a variety of investments are often included in a single IRA account. Almost any financial institution that offers investment opportunities of any kind also offers IRA accounts.
The traditional IRA, created in 1954, is best known and has been widely used. Most of the others in this group are quite similar except for their special areas of application.
Types of IRA’s
The SEP IRA, for example, is designed to help small business owners assist themselves and their employees with a common retirement plan when other plans might not be feasible. With this plan, employers can contribute directly to IRA accounts that are in the name of the employee.
A Simple IRA is similar in some ways in that it is designed for small businesses but it operates more like a 401k. It does have a more “simple” administrative load than a 401k, however.
For the ambitious (and more knowledgeable), there is the self-directed IRA. This IRA is distinguished by its provision for the owner to personally choose investments to place into the fund. Most funds allow many choices but this one allows more unusual investments such as real estate.
For many individuals the newer Roth IRA has become a preferred form of retirement investment. It is quite different from other IRA’s and is treated in a separate article specifically, How to Open a Roth IRA And Why.
Characteristics of the Traditional IRA
For many, the traditional IRA is still the preferred form of individual retirement account. It has several important characteristics.
- Contributions are made with pre-tax dollars
- Earnings within the IRA account are not taxed until withdrawn
- Withdrawals after age 59½ are taxed as normal income
The most notable attraction of a traditional IRA is that the investments are deductible from income when paying taxes. While originally the maximum contribution was only $2,000.00 annually for an individual, depending on income, that can now be as much as $6,000.00. This means your IRA contribution can make a significant impact on income taxes.
Since deposits are originally deducted from income, however, principal withdrawals are taxable income, as is any appreciated value. And withdrawals must begin at age 70½, so if income is anticipated to be high at that time the tax rate could be significant.
NOTE:
Carefully consider this option. If you begin late and anticipate a more meager retirement income, this can be a good choice. But if you begin a retirement program at an earlier age and anticipate a larger income from your IRA and other sources you may well expect to pay much more than if you paid taxes on this income now and choose a Roth IRA which also has many other benefits.
Early withdrawals (under age 59½) are subject to hefty fees (10%) in addition to income tax. There is also a significant penalty for not withdrawing required amounts beginning at age 70½, so care must be taken to understand the technical requirements of the traditional IRA for anyone deciding to use it.
A number of special rules have been adopted allowing early withdrawal for specified purposes. Up to $10,000 may be withdrawn for a first home. Money for medical expenses, higher education, certain medical expenses, health insurance and a few other uses may also be withdrawn without penalty, under certain conditions.
Your Best Individual Retirement Account
Whether a person is looking at a traditional IRA, Roth IRA, SEP IRA, Simple IRA, or Self-Directed IRA accounts, the important thing is to consider your individual needs in view of the options associated with each IRA type. And remember, you must think long term instead of short term to make the best choice for your IRA contributions.
