Types of IRA’s

With growing life expectancy living in retirement comprises a significant component of one’s life span. As such one needs to plan in advance to ensure financial stability and security during retirement. Investing in an IRA, or an Individual Retirement Account, is one of the tax efficient ways to plan for your retirement. There are many IRA schemes and one that is best for you would depend on your income, nature of work, and other personal factors.

Traditional IRA

Contributions to a Traditional IRA are made with pre-tax dollars. This means the IRS allows you to deduct your contribution from your income thus reducing your income tax. A Traditional IRA also allows your gains to be tax deferred until you begin to take distributions. If you participate in a qualified retirement plan at work and if the total income of you and your spouse exceeds a specific threshold, you may either be allowed only a partial deduction or no deduction at all.
Once you withdraw money from the IRA, you trigger additional income tax. The distribution will be considered regular income; it will be added to your other income and may or may not bump you to another tax rate. In other words, you become your own paymaster and should carefully consider the amount of distributions you elect.

RMD’s – Required Minimum Distributions kick in the year after you turn 70 ½. This is a forced distribution – you must take it even if you don’t want to. If you fail to do so, the IRS by default will forfeit half of the mandatory amount that is due for distribution.

Contributions – There are limits to the amount of annual contributions you can make into a traditional IRA. For the year 2012, If you are aged 49 years or below, your maximum contribution is $5000 while if you are 50 years or older, you can contribute $6000.

Roth IRA

Contrary to a traditional IRA, the contributions you make into a Roth IRA are after tax dollars and not eligible for an income tax deduction. But you reap the benefits of the plan upon reaching retirement. There are two thresholds that must be met in a Roth IRA. They are: the IRA must be five years old and the IRA owner must attain the age of 59 ½. When these thresholds are met the Roth advantage really begins. Once again you are your own paymaster but any distributions you take are tax-free. We like to explain it like this: you pay taxes on the seed but the harvest is totally tax-free. Remember you fund a Roth IRA with after tax dollars so if you need to withdraw funds before retirement, you can in a tax-free manner. It is a return of principle limited to your prior contributions.

Like a traditional IRA, there are limits to the amount of annual contributions you can make into a Roth IRA. If you are aged 49 years or below, your maximum contribution is $5000 while if you are 50 years or older, you can contribute $6000 (for 2012).
The age for penalty free withdrawals is at least 59 1/2; if you choose to withdraw money before this age, then you are exempted from the tax-free benefit – in such a case you are required to pay taxes and also a penalty of 10 per cent.

Required Minimum Distributions do NOT apply to Roth IRA’s. Therefore when you reach the age of 70 1/2, you can avoid taking the distribution if you wish. Your Roth IRA can be left to heirs – again tax free however the beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.

SEP IRA

SEP IRA stands for Simplified Employee Pension Individual Retirement Account. It is meant for self-employed people or a person who owns a business and employs others in it. They can make IRA contributions in a similar manner as traditional IRAs for themselves, as well as for their employees. The annual contributions that an employer can make to an employee’s SEP-IRA cannot exceed the lower of

  1. 25% of compensation -includes bonus and overtime, or
  2. $50,000 for 2012 and $51,000 for 2013.

In a SEP IRA, it is not mandatory to make contributions every year, but for all those years when contributions are made to the SEP, they must be made to the SEP-IRAs of all eligible employees.

The tax deduction allowed under a SEP IRA is subject to the lower of actual contributions to the employees’ SEP-IRAs or 25% of compensation. The upper limit of the compensation considered for each employee is limited to $250,000 in 2012 and $255,000 for 2013. Investments can be made in a number of things like bonds, stocks, mutual funds, and ETFs.

Self-Directed IRA

A self directed IRA allows you a great deal of freedom in choosing investment options for a retirement fund. Unlike a traditional IRA, where investment options are limited to stocks, mutual funds, and CD’s, in a self directed IRA you are free to invest your money into a host of other investment option which includes property, businesses, precious metals, and mortgages. Thus a self directed IRA allows an investor to maximize the return on his retirement portfolio by selectively investing in those assets which are most lucrative at that point in time. The minimum age for deriving the benefits with a tax-free status is 59.5.

Simple IRA

Simple IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. This IRA plan is provided specifically by the employer, and is best suited for small companies. Employees can invest some amount of money from their monthly incomes into the Simple IRA fund and the money grows at a specified interest rate until the person withdraws it upon reaching retirement.