Saving for retirement is one of those financial goals you know is important but you may not know how to go about starting or bolstering your nest egg. It’s a good idea to look into the different kinds of individual retirement accounts, or IRAs. These allow you a tax-advantaged way to save for retirement.
As opposed to 401(k)s, which are usually provided by your employer, an individual typically establishes IRAs. From traditional to Roth to SEP or even SIMPLE IRAs, each plan has different eligibility restrictions, caps and penalties. Understanding the types of IRAs available can help you figure out the best way to save for retirement.
The Traditional IRA
The traditional IRA is funded with pre-tax dollars and your earnings grow tax-deferred. Depending on your income, you may be able to deduct some or all of your contributions. At age 59 1/2, you can begin to take withdrawals without facing penalties, but you will have to pay income tax on the money you withdraw. If you take money out before then, you will have to pay an additional 10% tax as an early withdrawal penalty. However, you can take early distributions without paying the penalty if you are using the money to fund your first home, higher education expenses or qualifying medical expenses, but you will have to report it as income.
Once you are past 70 1/2 years old, you can no longer make contributions to a traditional IRA. You also must start withdrawing from your investments. There are limits to how much money you can put into a traditional IRA each year. Contributions made to a traditional IRA cannot exceed limits established by the Internal Revenue Service annually. Currently the limit is $5,500 (or $6,500 if you’re 50 or older). Since contributing to traditional IRAs reduces your taxable income and can lower your tax bill, it can be a good idea if you are looking to reduce your tax liability.
The Roth IRA
The Roth IRA is a a popular alternative to the traditional version. While contributions to a Roth IRA are not tax-deductible, the invested money, accrued interest and dividends all grow tax-free. Individuals can continue to contribute to these accounts at any age. You can leave money there throughout your lifetime or make tax- and penalty-free withdrawals after age 59 1/2 as long as the account has been open for five years. Though you can continue to contribute through retirement and are never required to start taking distributions, you must qualify for a Roth IRA based on your income. In 2014, you can contribute up to the limit if you are married filing jointly and your annual gross income is less than $181,000 or less than $114,000 if you are filing single. The contribution limits are the same for a Roth IRA as they are for traditional IRA.
Since you contribute to a traditional IRA on a pre-tax basis, it is a good way to reduce your taxable income in the present. It can be a good option for those who anticipate they will have a lower tax rate after retirement. You contribute to a Roth IRA after taxes, so it makes more sense if you think your tax rate will be higher in retirement. Essentially it’s a matter of when it makes more sense for you to pay taxes (when you will pay the least in taxes) — now or later.
The SEP IRA
A Simplified Employee Pension Individual Retirement Arrangement or SEP IRA plan lets business owners allocate money in retirement accounts for themselves and their employees. Any size business can utilize the SEP IRA. This year, that means they can contribute up to $52,000 or 25% of compensation, whichever is less. This plan can be good for a company that experiences variable cash flow from year to year since it does not carry high set-up or operating costs and allows for flexible annual contributions. The SEP IRA is also a good option for people who have self-employment income
The SIMPLE IRA
The SIMPLE IRA, or Savings Incentive Match Plan for Employees, plan allows you and your employer to contribute to a traditional-type IRA set up by the company. While employees have the option of contributing to a SIMPLE IRA, employers must. These usually do not carry heavy administrative burdens and is most commonly utilized by small businesses or startups with 100 or fewer employees that do not offer a retirement package. The SIMPLE IRA can be an option for self-employed people.
Once you’ve determined how much you need to save for retirement, it’s important to set up a plan to get you there and follow through. Without a plan, you could be facing debt in retirement. Debt can be inherited, and then follow your family members around for years. You can see how your debt is currently impacting your credit scores for free on Credit.com.
More Money-Saving Reads: