Some decisions don’t matter in the grand scheme of things. Choosing chocolate or vanilla (or double-fudge mint brownie supreme) will mainly affect your tastebuds, after all. Others require a bit more thinking, especially when it comes to your finances—and retirement plan.
Any time Uncle Sam offers to give you a break on your taxes, you should consider taking it, right? IRAs are one such break, but they’re not all the same. Each type of IRA has different eligibility requirements and tax advantages. Here’s a quick guide to help you compare IRA options and make the best decision for your savings.
First, are you eligible for an IRA?
There’s no sense in agonizing over the details of each type of IRA if you’re not eligible—so it’s good to apply the process of elimination here.
Number one, you need taxable income to open an IRA. So if you don’t have taxable income, you’ll want to consider other ways to save money, like certificates of deposit (CDs) and online savings accounts. Note: if you don’t have taxable income, are married, and you file your taxes jointly, your spouse may open and contribute to an IRA in your name.
What are the different types of IRAs?
If you have taxable income, you can get into comparing your IRA options. There are four basic types of IRAs, each with different eligibility requirements and tax advantages:
- Traditional IRAs allow you to deduct your contributions (subject to income levels). Your money is taxed when you take it out (take distributions) during retirement.
- Roth IRAs allow you to contribute after-tax dollars, so your distributions during retirement are tax-free.
- SEP (Simplified Employee Pension) IRAs are established by your employer or by you, if you’re self-employed. Contribution limits are higher than those for traditional IRAs.
- SIMPLE (Savings Incentive Match Plan for Employees) IRAs allow employers to set up IRA retirement plans for their workers and make matching contributions.
Depending on which type of IRA you choose, your contributions and earnings may be tax-deferred, or your earnings may be tax-free.
Use the chart below to help you determine which IRA might fit your situation best:
Keep in mind that the chart is meant as guidance only and income limits stated are for 2019. Qualifications and tax implications are more nuanced than we can show here, so be sure to consult with a tax professional familiar with your situation. It’s also a good idea to visit the IRS website for the most current information.
Roth vs. traditional IRA
Many people end up deciding between a Roth and a traditional IRA. If that’s you, you’ll want to determine when you want your tax break, since that’s the main difference between the two. In a nutshell:
With a traditional IRA, you can deduct your contributions (subject to income limits) toward your savings, up to an amount specified by the IRS. Your money is taxed when you make withdrawals (take distributions) during retirement, which you can begin making without withdrawal penalties at age 59½.
Note: after you reach age 70½, you have to be sure to withdraw a certain amount from your traditional IRA each year. These withdrawals are called required minimum distributions, or RMDs, and you may wind up paying a penalty if you don’t take them.
You make contributions to a Roth IRA after tax, and you can take distributions tax-free after age 59½. Since you pay taxes on the front end, you don’t have to worry about it later.
As you approach retirement, you can make so-called “catch-up contributions.” After age 50, the catch-up contribution is $1000 on top of the maximum contribution. For 2019, the maximum contribution limit is $6000. That means that after age 50, you can make a total contribution of $7000 per year.
If you’re your own boss (SEP vs. SIMPLE)
If you are a small business owner, a freelancer, or are self-employed, you have a couple more IRA options beyond the traditional or Roth, including the SEP IRA and the (less-common) SIMPLE IRA. Here are some details to consider:
A Simplified Employee Pension (SEP) is an account established by an employer or by someone who is self-employed. You take a tax deduction up front (subject to income limits) and then the distributions are taxable during retirement. The maximum contribution to a SEP IRA is up to 25% of an employee’s compensation. You can’t make catch up contributions to SEP IRAs.
A Savings Incentive Match Plan for Employees (SIMPLE) is a way for employers in small companies to set up IRA retirement plans for their workers. These plans operate a little like a 401(k): Employees can choose to have part of their paycheck go directly into their SIMPLE IRA, reducing their tax burden. Employers can make matching contributions.
Where can you open an IRA?
Once you’re pretty solid on which types work best for you, go over your goals and determine a course of action with a tax professional or financial advisor familiar with your situation. It’s always a good idea to check the IRS website for up-to-date information about things like contribution and deduction limits.
You can open any type of IRA at a bank or brokerage (types offered may vary by financial institution), and you can choose from a variety of deposit or investment options to put into the IRA account. Where you open your IRA largely depends on your goals for the account.
If it’s higher returns you’re after, you’ll need to find a brokerage, like Ally Invest, that offers investment services suited to your earnings goals. With Ally Invest, you can open a self-directed IRA and manage your own investments with a Self-Directed Trading account or let a team of investing professionals handle your Ally Invest Managed Portfolio for you.
If you’re more interested in the security of FDIC insurance, take a look at the IRA accounts offered by FDIC-insured banks. For example, you can open an IRA Certificate of Deposit (CD) or even an online savings account for your IRA.
Keep in mind that you can have more than one IRA, as long as your overall contributions don’t exceed government limits.
Your legwork will—literally—pay off.
Deciding which type of IRA to open isn’t something you can do on a whim, but the legwork involved in comparing IRA options is worth it. Rest assured that your well-thought out decision is something your future self will thank you for.