IRAs and Roth IRAs

IRA Basics

• What they are: Tax-advantaged savings accounts for individuals.
• Pros: Tax benefits; investments grow tax-deferred and contributions may be deductible; numerous investment choices with range of risk/reward characteristics.
• Cons: Early withdrawal penalties (plus income tax); annual contribution limits; some eligibility restrictions.
• How to invest: Directly through financial institutions – banks, mutual fund companies and brokerage firms.
• Tip: Start early and save as much as you can to take advantage of the power of compounding.

Think of an individual retirement account (IRA) as a savings account with tax advantages, plus the benefits of compounding. You open an IRA for just yourself (thus the individual in the name), so spouses have to open separate accounts. It’s important to note that an IRA is not an investment itself; instead, it’s an account where you keep investments – such as stocks, bonds and mutual funds. You choose the investments in the account and switch them around as you please. There are several types of IRAs, including traditional, Roth, SEP and SIMPLE. In many cases, you can have more than one type of IRA as long as you meet certain requirements.

Traditional vs. Roth

The main difference between a traditional IRA and a Roth IRA is when you are required to pay taxes on your contributions. With traditional IRAs, you pay taxes as you withdraw the money during retirement. With Roth IRAs, the taxes are paid as you put money into the account. The money grows tax free whether it’s in a traditional or Roth IRA.

Another difference is who can contribute: Nearly anyone with earned income can contribute to a traditional IRA, but your income might prevent you from contributing to a Roth IRA. Here are the IRS limits for tax year 2017: 

*modified adjusted gross income (MAGI)

For 2017, your total contributions to all of your traditional and Roth IRAs can’t be more than $5,500 ($6,500 if you’re age 50+), or your taxable compensation for the year if it was less than this limit. 

A third important difference is that, unlike other IRAs, there are no required minimum distributions (RMDs) from a Roth IRA (see below).

Other IRAs

Other popular types of IRAs include:

• Simplified Employee Pension (SEP): A type of traditional IRA set up by an employer for its employees. SEPs may be an option if you are self-employed, earn freelance income or if you are a small business owner with one or more employees. These have the same general features as traditional IRAs, but with much higher contribution limits: For 2017, contribution limits are the lesser of 25% of your compensation or $54,000 ($53,000 for 2016).  
• Savings Incentive Match Plan for Employees (SIMPLE): An IRA set up by a small employer for its employees. Unlike SEPs, employees can contribute to SIMPLE IRAs. For 2017 (and 2016), salary reduction contributions can’t exceed $12,500, and employers are generally required to match this on a dollar-for-dollar basis, up to 3% of the employee’s compensation.
• Spousal IRA: A traditional or Roth IRA funded by a married taxpayer on behalf of a spouse with no earned income. For 2017, you can put a maximum of $5,500 into a spousal IRA ($6,500 if the non-working spouse is age 50+ as of Dec. 31, 2017).

Required Minimum Distributions

Like 401(k)s, almost all IRA accounts – traditional, SEP and SIMPLE IRAs – are subject to required minimum distributions (RMDs). In general, you have to make withdrawals before April 1 of the year following the year you turn 70½. Every year thereafter, you have to take the RMD before Dec. 31. Roth IRAs are not subject to RMDs (see What Baby Boomers Need to Know About IRA RMDs.)

And, like 401(k)s, the amount you are required to withdraw as RMDs depends on your age, life expectancy and account balance. Typically, the RMD is calculated by dividing the prior end-of-year balance by a distribution factor listed (by age) in IRS Publication 590, Individual Retirement Arrangements. In some cases, you may end up using a different table. If your primary beneficiary, for example, is a spouse more than 10 years your junior, you have to use the Joint Life Expectancy Table.  (For more on required minimum distributions, read An Overview of Retirement Plan RMDs and Avoiding Mistakes in RMDs.)