In the not-so-distant past, workers didn’t have a lot of retirement savings options. Congress introduced Individual Retirement Arrangements (IRAs) in 1974, and they were pretty straightforward: if you didn’t have a retirement plan available at work, you could contribute up to $2,000 annually and deduct that from your taxes. If your spouse didn’t work, you could add that same contribution amount for his or her Spousal IRA, too. And that’s pretty much the only option you had.
Things have since changed, and much of it has been for the better. The average American’s retirement savings are woefully inadequate, so the IRS and Congress created additional IRA options; a lot of options. Sifting through the myriad of IRAs to determine which is right for you and your situation will make a big difference in reaching a comfortable retirement. So here are the various IRAs and a few of the particulars that distinguish them from the others.
As described above, a traditional IRA is the option most people are familiar with. One big difference today is participants are able to contribute up to $5,000 annually. The IRS has all the contribution particulars on their website. Like a lot of retirement plans, IRA contribution limits are indexed for inflation so often change each year.
The biggest differences between Roth and Traditional IRAs are the tax deductbility of contributions, and tax-free withdrawals. Roth IRA additions aren’t deductible from that year’s tax liability like with traditional IRAs. The other big difference is how the distributions are received. When money is taken from a Roth IRA at retirement, it’s tax-free, and that includes the tax-deferred earnings. That’s different than traditional IRAs, which are fully taxable at current rates when withdrawn.
Taking money from a Roth IRA is also more flexible. Unlike Traditional IRAs that impose distribution penalties before age 59 ½ and Required Minimum Distributions (RMDs) at age 70 ½, Roth IRAs offer more flexibility on both counts. For the particulars check out IRS Publication 590.
Small business owners also have IRA options available for themselves and their employees. Here are a few of the more common ones.
These are nothing more than traditional IRAs set up by an employer for an employee. Sure, each individual could set up his or her own IRA, but this plan provides more incentive for folks to contribute toward their retirement because many employers make contributing automatic, making it a lot easier to save. Most small employers have since opted for one of the newer, more flexible alternatives as described below.
Simplified Employee Pension (SEP)
SEP Plans, like many small business retirement plans, are essentially individual IRA accounts. One of the key differences with a SEP is the plan is set up and funded by the employer for the employee. What makes a SEP an attractive alternative for some are the increased contribution limits: up to $50,000 annually or 25% of annual income (whichever is less) in 2012. For the sole proprietor wanting to max out her retirement savings, a SEP is an attractive alternative.
The SIMPLE IRA, as the names implies, is a popular option for businesses with fewer than 100 employees that want to provide an easy to set up and administer plan. Unlike a 401(k) which requires mounds of IRS paperwork each year, a SIMPLE plan gives employers and employees the ease and flexibility of salary deduction, instant tax benefits, and few of the 401(k)-related headaches.
No doubt the number and types of IRAs have grown. That’s good news for employees, small business owners, and everyone saving for retirement. But along with the alternatives comes the need for some homework to determine which IRA is right for you.