IRAs are one of the most popular types of savings accounts because of their considerable tax advantages. They allow retirement savers to grow their money on a tax-deferred basis -- which means their investments are exempt from capital-gains taxes and dividend taxes -- until they retire. But which type of IRA is right for you? The answer will depend on your goals and circumstances.
Types of IRAs
The original and most popular type of IRA is the traditional IRA, which allows you to make tax-deductible contributions and then pay ordinary income tax on your withdrawals at retirement. You are allowed to contribute the lesser of $5,500 or 100% of your earned income to a traditional IRA in 2017. If you are 50 years old or older, then you are allowed to contribute an additional $1,000 as a "catch-up" contribution. However, participants who have incomes above a certain amount will lose the ability to deduct some or all of their contributions, and those limits are even lower for those who are also contributing to an employer-sponsored retirement plan. This amount is adjusted annually in order to keep pace with inflation. You can learn more about traditional IRA limits here.
Roth IRAs are funded with after-tax contributions, so you cannot take a deduction for your contributions. But the income you take out of it at retirement will be tax-free as long as you are at least 59-1/2 years old and have had a Roth account or plan of some sort open for at least five years. Roth IRAs have the same contribution limits as traditional IRAs, but you cannot contribute directly to a Roth IRA if your adjusted gross income exceeds a certain amount. Fortunately, there is a backdoor contribution strategy that allows you to fund a Roth IRA by contributing to a nondeductible IRA and converting that amount to the Roth IRA. A special set of rules applies if you have money in other traditional IRAs that may require you to report some or all of the conversion amount as income. Learn more about Roth IRAs here.
SEP-IRAs are designed for self-employed taxpayers who wish to save more money for retirement than they are allowed to in traditional or Roth IRAs. These accounts allow you to sock away up to $54,000 in 2017. Like traditional IRAs, they are funded with deductible contributions and are taxed upon withdrawal at retirement. Learn more about SEP IRAs here.
SIMPLE IRAs are group retirement plans that allow employees to defer money from their earnings into the plan. The employer is required to make matching contributions up to certain limits (3% for elective deferrals or 2% for non-elective deferrals). Employees can contribute up to $12,500 in these plans in 2017. Learn more about SIMPLE IRAs here.
Which is best?
So which type of IRA is right for you? The answer depends on several factors, such as your current tax bracket and the tax bracket you expect to be in when you retire. If you think you'll be in a lower tax bracket when you retire than you are in now, then a traditional IRA may provide you with greater tax savings as long as you are allowed to deduct your contributions. A Roth IRA may be the better option if it looks like you will be in a higher tax bracket when you retire, because you will not pay taxes on your distributions. A Roth may also be the better option if you're participating in an employer-sponsored retirement plan and your income is too high to allow you to deduct any contributions made to a traditional IRA. If your income is also too high to contribute to a Roth IRA, then you can use the backdoor contribution method described above.
If you're self-employed, then a SEP-IRA would most likely be the obvious choice, especially if you want to contribute more than you can to a traditional or Roth IRA. If you own a small business with less than 100 employees, then a SIMPLE IRA will allow you and your employees to defer a portion of your earnings for retirement.
IRAs are an excellent way to save for retirement. Open one today and get started with saving for your future.
The Motley Fool has a disclosure policy.