There are several different types of Individual Retirement Accounts which provide tax advantages for retirement savings. IRAs can be invested in virtually any security instruments that the account owner wants, making them very flexible. IRAs generally do, however, come with a number of important restrictions, as well. Let’s take a look at five types of IRAs:
- Traditional IRA - The Traditional Individual Retirement Account is by far the most popular IRA. The IRA is held at a custodian such as a bank or brokerage, and may be invested in anything that the custodian allows. Unlike the Roth IRA, the only criterion for being eligible to contribute to a Traditional IRA is sufficient income to make the contribution. However, the best provision of a Traditional IRA—the tax-deductibility of contributions—has strict eligibility requirements based on income, filing status, and availability of other retirement plans (mandated by the Internal Revenue Service). Transactions in the account, including interest, dividends, and capital gains, are not subject to tax while still in the account, but upon withdrawal (or distribution) the funds are taxed as ordinary income.
- Education IRA - An education IRA (which really isn't an IRA at all) is a custodial account or trust, usually maintained by a bank or financial organization, exclusively for the purpose of paying the qualified higher-education expenses of the designated beneficiary. Education IRAs must accept contributions only in cash, and cannot accept contributions for a beneficiary after he or she turns 18. In addition, the education IRA cannot accept contributions of more than $500 (except for rollover contributions) for any single year.
- SEP (Simplified Employee Pension) IRA - The SEP IRA is a company-sponsored IRA that can be opened by small businesses and sole proprietors. There are no real administration costs if you are self-employed and don't have any employees. If you do have employees, all must receive the same benefits under a SEP plan. Since SEP accounts are treated as IRAs, funds can be invested in the same manner as any other IRA.
- SIMPLE (Savings Incentive Match Plan for Employees) IRA - This is a type of Individual Retirement Account that is set up to be an employer-provided plan. It is a qualified plan like more well-known plans such as the 401(k) Profit-Sharing plan and 403(b) Tax Sheltered Annuity plan, but offers simpler and less costly administration rules. Like the 401(k), the SIMPLE IRA is funded by a pre-tax salary contribution. Contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans.
- Roth IRA - The Roth IRA's main advantage over Traditional IRAs is its tax structure. Contributions are not tax-deductible and are made only from earned income which has already been taxed; however, withdrawals up to the total of the contributions are federal income tax-free, and withdrawals of earnings (anything above the total of contributions) are generally tax-free. In contrast, contributions to a Traditional IRA may be tax deductible if certain eligibility requirements are met, but withdrawals are taxed as ordinary income. Another advantage of the Roth IRA over Traditional IRAs is that there are fewer restrictions and requirements on withdrawals.