Posted by Jim McClaflin, EA, NTPI Fellow

The Different Types of IRA’s in Regards to Tax Savings

The Different Types of IRA’s in Regards to Tax Savings

Traditional and Roth IRAs may be the king and queen of the retirement prom, but there are other great options that savers shouldn't ignore.

Although there are lesser-known SEP, SIMPLE, spousal, and other types of individual retirement accounts offer the same, and sometimes better, benefits that increase money and save taxes. The choice of IRA may vary based on income, employment status, vacancies, and other factors.

Here are the basics of seven types of IRAs to help you decide which ones (or one) will give you the most financial benefits and help you save on your taxes.


Traditional IRA

According to data from the Investment Company Institute, the traditional IRA remains the most popular retirement savings account with individual tax benefits. Typical features include:

  • An initial tax reduction of up to $6,000 in 2020 and 2021, plus an additional clawback contribution of $1,000 if you are 50 or older - contributions may be deductible, reducing your taxable income for that year. It all depends on your current income and whether you or your spouse has a retirement plan at work.

  • Investment income is not taxable as long as the money remains under the protection of the account.

  • Retirement withdrawals are taxed at the prevailing tax rate.

Best for those in a massive but high category who will be retiring, as well as workers who do not have access to (or are not eligible to contribute) to a sponsored workplace pension plan.


Roth IRA

The Roth IRA offers a good balance of the traditional IRA tax savings. Here are its main characteristics:

  • Although contributions are not deductible, which means that there is no initial tax exemption, pensions during retirement are fully tax-exempt.

  • The maximum annual membership fee is $6,000 ($7,000 if you are over 50). Eligibility to contribute to a Roth is based on your income, but if you earn a lot for contributing, there is a perfectly legal way to open one through the back door Roth.

  • Roth IRA withdrawal rules are more lenient and allow withdrawal of contributions and non-taxable penalties at any time. Taxes and fines apply to the withdrawal of earnings before retirement, with a few exceptions.

Savers who intend to be in a higher retirement tax category to take advantage of these tax-free withdrawals. A Roth is also a better option than a traditional IRA if you need to access some of the money before retirement age. However, it is recommended that you don't dip into your retirement savings early. 


SEP IRA

The first three letters SEP represent the simplified employee pension. Although this is a traditional type of IRA, an employer sets it up and funds it for the employees who receive tax benefits for this effort. In a SEP IRA, the increase in non-taxable income and distributions during retirement are taxable. Other attractions:

  • Annual contribution limits are much higher than those allowed in other tax retirement accounts - the lowest is up to 25% of the employee's salary or $57,000 in 2020 and $58,000 in 2021.

  • The employer must contribute equally (or a percentage of salary) to the accounts of all employees, including his own.

  • The contribution amount may vary from year to year, depending on its cash flow, but it must always be the same for all eligible workers.

  • Employees cannot contribute to the plan by deferral of salary; you must have worked for your employer for at least three of the past five years and must have earned compensation of at least $600 during the year to be eligible.

  • Sole proprietors can open a SEP IRA independently.

  • Catch-up contributions are not allowed for workers over 50.

Small business owners who want to avoid the initial and operational costs of a conventional pension plan, as well as the ability to increase the amount of the pension reserve and get a tax deduction for employee contributions. Remember that it is important to follow the SEP-IRA rules to avoid conflicts with the IRS if you are the employer and the employee.


Nondeductible IRA

If you (or your spouse) have a working retirement plan and your income exceeds the IRA income limits, you may not be able to deduct traditional IRA contributions. But you can deposit money into the IRA. The main things you should know about a nondeductible IRA:

• Contributions are made in after-tax dollars and, as the name suggests, are not deductible. 

• You will continue to benefit from an increase in deferred tax revenue on your account.

• Retirement taxes are paid for any increase in income withdrawn, but not for principle, as the account was funded from pre-tax dollars.

Those who are not eligible to contribute to a deductible IRA or Roth IRA can grab this with both hands.


Spousal IRA

IRS rules state that a person must have earned income to contribute to an IRA. But there is a solution for married taxpayers: If half the couple is not working or has a very low income, both can contribute to their IRA (Roth or traditional).

  • Couples must file a joint tax return and have taxable compensation to be eligible.

  • The contribution limits are the same as for a traditional IRA or Roth: the spouse who is not working can contribute up to $6,000 or $7,000 for people over 50 in 2020 and 2021. The spouse who works can contribute the same amount to your IRA.

  • The total amount contributed to the two IRAs must be less than the combined taxable income or double the annual contribution limit for the IRA (for example, $12,000 for those under 50).

  • The account can be funded with money from either spouse's income but must be opened in the non-working spouse's name using their social security number.

This is good for low-income or unemployed people married to a low-income person.


SIMPLE IRA

SIMPLE IRAs are similar in many ways to an employer-sponsored 401(k) plan. It exists primarily for small independent businesses. Unlike SEP IRAs, employees can contribute to the account by deferring their salary. Some plans even allow employees to choose the financial institution they wish to use to maintain their accounts. The simple IRA tax rules are very similar to those that apply to traditional IRAs. Other considerations:

  • Contribution limits are lower than 401(k)s - $13,500 compared to $19,500 in 2020 and 2021.

  • Employers are generally required to contribute a matching contribution of 3% or a fixed contribution of 2% of each eligible employee's salary.

  • To be eligible for a SIMPLE IRA, an employee must have earned at least $5,000 in the two years preceding the current calendar year and expect to receive at least that amount in the current year.

  • •, Unlike SEP, upgrade contributions are allowed - if you are over 50, you can save an additional $3,000.

  • Unlike most work plans, participants can transfer money from their account to a traditional IRA after two years of participating in the SIMPLE IRA.

  • Early withdrawals from a SIMPLE IRA within the first two years of contributing to the account may be subject to a 25% penalty (in addition to normal income tax).

Small businesses with less than 100 employees can benefit from this. If you are self-employed, it is best to open a SEP IRA for higher contribution limits.


Self-directed IRA

The same contribution and eligibility rules govern self-directed IRAs (Traditional and Roth) as Traditional and Roth IRAs, except for one big difference: what goes into the account.

The other IRAs covered in this article generally limit investments in the account to mutual vehicles, such as stocks, bonds, and mutual funds. In a self-directed IRA, you can own assets such as real estate, tangible assets such as gold, and private companies. Some things you should know:

  • To create one, you need an administrator or custodian specializing in the less common types of investments you want to keep in your account.

  • The IRS does not allow the storage of items such as collections and life insurance.

  • There are many prohibited "sale" transactions in a self-directed IRA (for example, mowing the lawn or repairing the battery on a leased property owned by the IRA) that the IRS considers equivalent to a distribution. This can result in taxes and fines on the entire account.

Experienced investors who want access to alternative investments such as real estate and non-traditional businesses would love this type of IRA. While using this type of account to save for retirement is beneficial (especially the potential for higher returns), don't pass go until you understand the risks of self-directed IRAs.


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Jim McClaflin, EA, NTPI Fellow
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