An individual retirement account (IRA) is a tax-advantaged savings tool. It is not an investment itself, but a container for investments (stocks, bonds, CDs, mutual funds, ETFs, and so forth) that offers benefits in exchange for your compliance with a set of rules.
IRAs are a broad category encompassing several individual varieties. There are traditional and Roth IRAs, which, generally speaking, individuals can set up for themselves. I say “generally speaking” because there are a couple subsets of traditional IRAs that must be set up by an employer: Simplified Employee Pension (SEP) plan IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
Essentially, the only detail traditional and Roth IRAs have in common is their contribution deadline. Contributions can typically be made up to April 15th of the year following the year for which they are for. However, keep in mind it’s best to max out your annual limit as soon as possible in order to reap the potential benefits of gains and compounding.
Now let’s see what makes each variety unique.
Who Can Contribute. If you have taxable compensation and are under the age of 70½, you may contribute to a traditional IRA, regardless of how much you make.
You may claim a state and federal tax deduction for making contributions to a traditional IRA, but it will be limited if you or your spouse is covered by a retirement plan through work. Refer to the IRS’ IRA deduction limits page.
Earnings in the account grow tax-deferred, but when you withdraw from a traditional IRA, you’ll owe full income taxes on contributions you got a tax deduction for and on any earnings.
Required Minimum Distributions. “Distributions” simply refer to withdrawals from a retirement account. Unlike a Roth IRA, you must begin taking withdrawals, required minimum distributions (RMDs), by April 1st of the calendar year following the year you turn 70½.
Employer-Sponsored Traditional IRAs
Simplified Employee Pension (SEP) Plan IRA.
SEP plan IRAs, or SEP-IRAs, are a form of traditional IRA that employers set up to provide retirement benefits for themselves and their employees.
Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
SIMPLE IRAs are a kind of traditional IRA that small employers (100 employees or fewer) or self-employed individuals can set up.
Roth IRAs have a special advantage over many other retirement accounts including traditional IRAs because you can take out contributions at any time without penalty and more often than not have a wider variety of investment options.
Who Can Contribute. Whereas one must be under the age of 70½ to contribute to a traditional IRA, you can contribute at any age so long as you have taxable compensation and meet income limits.
In order to contribute to a Roth IRA, one’s modified adjusted gross income must be be under $133,000 for individuals or $196,000 for married couples filing jointly, per 2017 income limits set by the IRS.
Individuals 49 and under may contribute up to $5,500 to a Roth IRA, while those ages 50 and over may contribute up to $6,500, per 2017 contribution limits set by the IRS.
Taxes. Unlike traditional IRAs, Roth IRA contributions are not tax deductible. Although contributions can be withdrawn from a Roth IRA at any time without incurring a penalty or tax (since taxes were paid on contributions before going into the account), that is not the case with interest/earnings on contributions that have accrued.
In order to avoid a 10% penalty on top of having to pay the full income tax on earnings in a Roth IRA account, one must both have reached the age of 59½ and have had the account for a minimum of 5 years—well, actually, that isn’t technically true.
The 5-year period is counted from January 1st of the taxable year during which the first contribution was made. As mentioned earlier, contributions can typically be made up to April 15th of the year following the year for which they are designated for (the year they’ll count against the contribution limit). Thus, it doesn’t have to be a full five years: If you made your first contribution for 2017 on April 15th, 2018, you would have gotten a 15½ month head start on the 5-year period.
Qualified distributions may be withdrawn tax and penalty free (including earnings). A “qualified distribution” is any payment or distribution from your Roth IRA that is made following said 5-year period and meets one of the following additional requirements:
• Made by the date you reach the age of 59½
• Made due to a disability
• Made to a beneficiary or your estate following your death
• Made to pay for a “first” home, up to a $10,000 life limit (the IRS considers a home your “first” if you [or your spouse, if you’re married] haven’t owned a home used as a principal residence within the two years prior to purchasing it)