One of the best ways to plan for retirement is by contributing to an IRA (Individual Retirement Account). However, there are five different types of IRAs that money can be deposited into. It is important to understand the function and limits of the different types of IRAs to make the most financially sound decisions when investing money.
The first type of IRA is a traditional IRA, which is available to everyone and has no income restrictions. A traditional IRA allows the investor to contribute income to an individual savings account prior to it being taxed, because taxes are paid when the earnings are able to be withdrawn at age 59½. Withdrawal of funds is mandatory at age 70½. A certain amount of pretax contributions are tax deductible based on the adjusted gross income of the investor. In the event of a complete early withdrawal of funds, most people will pay a 10% penalty.
A Roth IRA is another one of the different types of IRAs for an individual investor. A Roth IRA is only available to couples that make below $150,000 US Dollars (USD) and single people that make below $95,000 USD per year. Contributions to Roth IRAs are made after income taxes have been made. However, the Roth account grows tax free and taxes are not paid upon distribution which has no mandatory age. Penalties for early withdrawal of funds only apply in the first five years that a Roth IRA is opened.
Two types of IRA’s that are opened and funded by an employer are SEP (Simplified Employee Pension) IRAs and Simple IRAs. SEP IRA’s allow the employer to contribute up to a certain percentage of an employee’s income into their account. The money can be withdrawn at anytime, but will garner a 10% penalty prior to age 59 ½. Employees must pay taxes on the earnings in the year the withdrawal was received, however, funds in a SEP IRA can be rolled into a traditional or Roth IRA without being taxed or paying a penalty. A Simple IRA is similar to a SEP with the major difference being that the employee may contribute up to 100% of the employer contribution up to maximum of $6500 USD per year.
The last of the different types of IRAs is the Education IRA, also called a Coverdell ESA (Education Savings Account). The Education IRA allows parents to put away up to $2,000 USD per year in a tax-deferred IRA that is to be used to supplement the cost of post-secondary education for their child. As long as the funds are used for educational purposes, they will remain tax-free.