Retirement savings accounts are like toothpaste (seriously, bear with us). At the store you’ll find racks and racks of them – dozens of different brands all offering different things. You only want one – how on earth are you going to choose?
Look a little closer and you’ll see they subdivide into a few basic categories (as does toothpaste – kids, adults, whitening, sensitivity, dentures). Decide on which type of IRA you want and your decision’s suddenly a lot easier. Hopefully, you’ll smile more too.
Let’s look at the five most common types of IRA, what they offer, how they work and compare some of the pros and cons. We’ll answer questions such as: what is an IRA and what at the benefits of a traditional IRA vs Roth IRA?
Traditional IRA
The oldest and most popular investment retirement account, the traditional IRA offers a tax break for 2020/21 of $6000, with a $1000 add-on for investors over 50.
Depending on your domestic situation (your income plus whether you have a partner with a workplace retirement fund) you may also be able to deduct your payments from taxable income.
While your cash remains in the IRA it won’t be taxed, although withdrawals during retirement will be taxable at the current rate.
If you’re not eligible for or can’t contribute to a workplace retirement account, and you think you’ll experience a significant tax-bracket drop after retirement, this could be a good choice for you.
PROS: Tax-deductibility and 50+ bonus, protection from tax whilst held in account.
CONS: post-retirement deductions are taxable, and partner’s income and savings may affect it.
BEST FOR: Those without workplace pension pots whose income may decline.
Roth IRA
This is sort of a mirror-image of the traditional IRA in that you are taxed on money you pay into the account but NOT on money withdrawn on retirement. You can only contribute a maximum of $6000 per year ($7000 once over 50).
Eligibility is based on income but if yours is too high, try a Backdoor IRA (as outlined below).
Withdrawals prior to retirement are permissible without taxes and penalties, making this a good choice for someone who requires flexibility and anticipates being in a higher tax bracket upon retirement.
It might not be a great choice if you want to save but find yourself tempted to make early withdrawals, as there are few impediments to borrowing from it before you hit retirement.
PROS: Tax-free post-retirement withdrawals, withdrawals before maturation are permissible.
CONS: Tax applies to contributions. Cap on annual payments. Requires discipline not to dip into.
BEST FOR: Strict savers on middle incomes whose wealth is likely to grow.
Rollover IRA
If you’re unhappy with your current 401K and are thinking of taking it to an independent provider, you can obtain a rollover IRA. This folds your workplace savings into a new account, preserving the tax-deferred status of the money you’ve already saved.
Even better, you won’t pay early withdrawal fees or current taxes on the income you transfer. Once you’ve made the transfer, you’ll usually find you have a greater choice of investment options, especially as these are growing all the time.
You might, for instance, diversify into stocks, bonds, mutual funds or even cryptocurrency, depending on what the IRA company offers.
You can rollover into a Roth IRA or a Traditional IRA and the terms will depend on what the provider offers.
PROS: Better terms and a more diversifiable investment portfolio.
CONS: Make sure you’re not moving from a secure 401K to a riskier IRA – take independent advice.
BEST FOR: Those stuck in underperforming workplace investment retirement accounts.
Backdoor IRA
This is a cunning (and legal) way to obtain a Roth IRA if your taxable income is over the normal threshold. At the moment, high rollers can’t pay into Roth IRAs if their current income is over certain thresholds ($140,000 for single filers and $208,000 for those on joint incomes).
However, you can convert a traditional IRA into a Roth IRA. Here are the steps you need to take to take advantage of the current loophole:
1. Convert your existing IRA into a Roth IRA. You’ll get the necessary paperwork from your IRA administrator.
2. Pay tax on the IRA contributions you made (since in a Roth IRA they are no longer protected).
3. Pay capital gains tax on anything that has accrued in your traditional IRA. Report this on your federal income tax return.
While this may sound like a lot of tax to pay to enable the transfer, remember that your post-retirement withdrawals are tax-free.
PROS: Gives you a Roth IRA even if you’re above the threshold.
CONS: A little fiddly and you’ll have a tax payout at point of transfer.
BEST FOR: High earners who want to take advantage of a Roth IRA’s tax-free payouts.
Roth 401K
This IRA combines the benefits of a traditional 401K employer-sponsored pension pot and a Roth IRA, with its post-retirement tax breaks.
You can contribute up to $19,500 (as of 2020/21) annually, with an additional $6,500 for those aged over 50.
As with a Roth IRA, you won’t pay tax on post-retirement withdrawals, but you are taxed on contributions. You’ll also benefit from whatever contribution your employer makes as well.
Obviously, these IRAs are tied to your job and any other benefits you receive, plus investment options, will depend on your employer. However, you can in future rollover to a standard Roth IRA.
PROS: Combines the high contribution limits of a traditional IRA with tax-free withdrawals of a Roth.
CONS: Tied to your employment, you pay tax on all contributions.
BEST FOR: Those who expect to retire in a higher income bracket, whose workplace 401K is good.
If you’re considering a Roth IRA, here’s a handy Roth IRA Calculator.
And there you go those are the five most common types of IRA accounts. The Traditional IRA, Roth IRA, Rollover IRA, Backdoor IRA, and Roth 401k.
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