Traditional IRA
Traditional IRAs are funded with pre-tax money. Money grows on a tax-deferred basis, but withdrawals are taxable as regular income. Depending on your income and whether you or your spouse has a workplace retirement account, traditional IRA contributions could be tax-deductible. You'll generally owe a 10% early withdrawal penalty, plus income taxes, if you take money out of the account before age 59 1/2.
Roth IRA
Roth IRAs are funded with money you've already paid taxes on, so contributions are never tax-deductible. However, your money grows on a tax-deferred basis, and if you wait until age 59 1/2 and you've had the account for at least five years, your withdrawals will be tax-free and penalty-free.
You can also withdraw your contributions (but not the earnings) at any time, tax- and penalty-free. But if an early withdrawal cuts into the earnings portion of the account, you'll owe taxes and a 10% penalty on the earnings.
To contribute directly, you can't earn more than the Roth IRA income limits for the year. However, some high-income people use what's called a backdoor Roth IRA strategy to get around this rule.
Other types of IRAs
There are a few other types of IRAs designed for specific situations, but they'll always be structured as a pre-tax account or a Roth account. Some examples include:
- Rollover IRAs are set up to hold money that you've rolled over from a 401(k) or a similar workplace retirement account to maintain its tax advantages and avoid penalties.
- Spousal IRAs are regular IRAs that are set up for a non-working spouse. To be eligible for a spousal IRA, couples must file a joint tax return.
- Inherited IRAs are used to hold inherited retirement accounts, like 401(k)s and IRAs, for a beneficiary.
- SIMPLE IRAs are IRAs for businesses with 100 or fewer employees. Employers typically must contribute either a flat 2% of each worker's pay or offer a 3% match.
- SEP IRAs are IRAs for self-employed people and those who own very small businesses. Owners must contribute the same percentage of each eligible worker's salary (including their own) to a SEP IRA. Only employers can contribute to SEP IRAs.
- Custodial IRAs are IRAs set up on behalf of a minor. An adult will need to manage the account until the child reaches the age of majority in their state.
