Understanding the Different Types of IRAs

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.

Written By

Reviewed By

Updated on Wednesday, December 12, 2018

small jar full of change with a small plant growing out of it
iStock

Chances are you know how important it is to save for retirement — but you’re still behind. A recent MagnifyMoney study found that the median retirement savings for households headed by 30-somethings was about $23,000 — far below the recommended amount.

If you’re one of the many people with insufficient retirement savings, it’s important to explore all the retirement options available to you. That’s why it’s essential to know about retirement vehicles like 401(k)s and individual retirement accounts (IRAs).

What is an IRA?

The IRA was created by the Internal Revenue Service (IRS) to give individual investors another way to save for retirement. Rather than socking away your money in a savings account, you can contribute to an IRA, which allows you to take advantage of market gains, helping your money grow faster. There may even be some tax benefits to using an IRA.

There are several types of IRAs available:

  1. Traditional IRA
  2. Roth IRA
  3. SEP IRA
  4. SIMPLE IRA
  5. Rollover IRA
  6. Spousal IRA
  7. Nondeductible IRA
  8. Inherited IRA
  9. Education IRA

financial advisor

6 popular IRA types

While there are many different types of IRAs, you probably won’t use all of them. In fact, you’ll most likely use just one or two of the most common types in your lifetime. Below are six of the most popular IRA types available.

1. Traditional IRA

  • Who it’s best for: Ideal for workers who don’t have access to an employer-sponsored retirement plan.
  • Contribution limits: In 2020, you can contribute up to $6,000 per year (or $7,000 if you’re 50 or older).
  • Tax treatment: If you aren’t covered by a retirement plan at work, you can deduct the full amount of your contribution on your tax return.

A traditional IRA is one of the most common forms of IRAs. You can open and contribute to a traditional IRA until you reach the age of 70 and a half. You can open one as your sole retirement vehicle — as some self-employed people do — or as a supplement to a 401(k) plan. There’s no income limit, so you can contribute to a traditional IRA regardless of how much money you make.

According to Paul T. Joseph, an attorney and certified public accountant, a traditional IRA offers substantial benefits.

“The traditional IRA allows you to invest money into a tax-deferred account, which you can invest and allow to grow tax-sheltered until you withdraw the money or are compelled to withdraw the money at age 70 and a half,” said Joseph. “You receive a tax benefit upon the deposit into the account, and the account grows tax deferred until withdrawal.”

2. Roth IRA

  • Who it’s best for: Ideal for low- and middle-income workers.
  • Contribution limits: In 2020, you can contribute up to $6,000 per year (or $7,000 if you’re 50 or older).
  • Tax treatment: Funds are contributed post-tax, which means the withdrawals are not taxed in retirement.

Roth IRAs can be powerful savings tools, but they differ from traditional IRAs. When you open a Roth IRA, contributions are made after you pay taxes on the money. While you don’t get the upfront tax benefit, Roth IRAs offer a unique perk once you retire.

“When you decide you want to withdraw money from the Roth IRA account, any earnings made in the account are tax-free,” said Joseph. “The investment must stay in the account for at least five years to qualify. With a Roth IRA, you are not compelled to begin withdrawals at age 70 and a half.”

Not everyone can contribute to a Roth IRA. As of 2020, you can contribute the full amount only if you make under $196,000 and file a joint tax return (or are a qualifying widow or widower). If you make more than $196,000 but less than $206,000, you can contribute a reduced amount. If you make over $206,000, you’re ineligible for a Roth IRA altogether.

3. SEP IRA

  • Who it’s best for: Business owners who want to offer their employees a retirement plan as well as freelancers.
  • Contribution limits: In 2020, employers can contribute up to 25% of compensation or $57,000, whichever is less. Self-employed individuals can contribute up to 25% of their net earnings from self-employment (not including contributions for themselves), as much as $57,000.
  • Tax treatment: Contributions are tax-deductible.

A simplified employee pension (SEP) IRA is a tax-deferred retirement plan for small-business owners, self-employed individuals and freelancers. Generally, SEP IRAs are good accounts for business owners who want to contribute to their employees’ retirements. With these accounts, the employer contributes on the employee’s behalf.

4. SIMPLE IRA

  • Who it’s best for: Small-business owners who want to make tax-deferred contributions to an employee’s plan.
  • Contribution limits: In 2020, employers can contribute up to 3% of the employee’s compensation as an employer match, or 2% of the employee’s compensation if the employee doesn’t contribute. The employee contribution limit for 2020 is $13,500.
  • Tax treatment: Contributions are tax-deductible and required every year.

A savings incentive match plan for employees (SIMPLE) IRA is for small-business owners — businesses with 100 employees or fewer — who want to offer a tax-deferred retirement plan. A SIMPLE IRA requires contributions from the employer, which can be made on their own or to match an employee’s contributions.

Employees are eligible if they received at least $5,000 in compensation from the employer in any two preceding years and are expected to earn at least $5,000 in the current year.

5. Rollover IRA

  • Who it’s best for: Employees with 401(k) accounts from past employers.
  • Contribution limits: The same as the contribution limits for traditional IRAs: up to $6,000 per year in 2020 (or $7,000 if you’re 50 or older). You can roll over the full amount of your 401(k).
  • Tax treatment: Roll over your account balance, and all future contributions are tax-deferred.

Deciding exactly what you should do with a 401(k) when you leave a job can be tricky. Cashing it out causes you to lose money, so a better idea is to roll it over into an IRA. With this approach, you transfer the 401(k) funds into an IRA. The new rollover IRA allows you to keep the full balance and continue to contribute to your account. You can complete a rollover online within minutes through online investment companies.

6. Spousal IRA

  • Who it’s best for: Nonworking spouses.
  • Contribution limits: You can contribute up to $6,000 per year in 2020 (or $7,000 if you’re 50 or older).
  • Tax treatment: Contributions are tax-deductible.

It can feel like your retirement options are limited if you aren’t working. The IRS allows nonworking or low-income spouses to contribute household income into an IRA to save for the future.

“In some situations where a married couple only has one party earning income, they are still able to create a spousal IRA and place money into the IRA for the benefit of the nonworking spouse,” said Joseph. “Provided you don’t exceed your earned income, you can essentially double your contributions into an IRA through the use of a spousal IRA.”

A spousal IRA can be either a traditional IRA or Roth IRA, depending on your preference and income. Depending on the account you choose, you can deduct the amount you contribute and watch the money grow tax-deferred over time. It’s a powerful option that can help your retirement nest egg grow as a couple.

How to open an IRA

Opening an IRA is a relatively easy process. To get started, identify which type of IRA is best for you. Then choose a bank or financial institution to hold your investments. Companies like Vanguard, Fidelity, TD Ameritrade and Betterment all offer IRAs.

Depending on the company you choose, you may need anywhere from $500 to $1,000 to open an account. Once you open the account — which takes just a few minutes online — you can choose your mix of investments to design your portfolio.

Not sure which investments to choose? Learn about mutual funds and ETFs and which is best for you.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Do you have a question?