Which Type of IRA Is Best for You?

Which Type of IRA Is Best for You? article image.

Putting your money into an individual retirement account (IRA) can help you get to retirement faster and with a few more dollars in hand. According to the Investment Company Institute, assets in IRAs totaled $13.2 trillion at the end of the second quarter of 2021, accounting for just over 35% of total retirement assets. Along with employer-funded retirement plans, government pensions and Social Security, IRAs play a key role in supporting retirees in their post-career years.

But there's more than one type of IRA, and choosing the right account when you're trying to set up an IRA can be confusing. The type of IRA that's best for you will depend on your individual situation. Here's how a few of the most familiar types of IRAs work—and how they might work for you.

Traditional IRA

Traditional IRAs give your retirement savings a boost by allowing you to defer the taxes you pay on your earnings. Though you get a nice tax deduction now, you'll pay taxes on both contributions and earnings when you withdraw your money.

  • Qualifying contributions are tax-deductible up to $6,000 each year, and $7,000 if you're 50 or older.
  • Your money grows tax-free as long as it stays in your account.
  • Withdrawals are taxed as income when you retire.

The IRS limits the amount you can contribute to a traditional IRA based on income and whether you or your spouse have a retirement plan at work, such as a 401(k). In 2021, allowable deductions begin phasing out for single taxpayers with adjusted gross incomes over $66,000 and $105,000 for married couples filing jointly. Any withdrawals from a traditional IRA are taxable. If you're under 59½, your withdrawal may be subject to an additional 10% in taxes. Check with the IRS for distribution guidelines and details.

Roth IRA

Roth IRAs also offer tax benefits, but instead of deducting your contributions now, you can withdraw money from your Roth IRA tax-free when you retire.

  • No tax deductions: Your Roth is funded with post-tax dollars.
  • Your money grows tax-free within your account.
  • You may withdraw your Roth IRA contributions at any time. If you withdraw earnings from your account, you may trigger an additional tax and penalty.

Because distributions are tax-free, the money in a Roth IRA goes farther in retirement, and the additional flexibility on withdrawals may come in handy if you ever face an emergency. Like traditional IRAs, Roth contributions are capped at $6,000 (or $7,000 if you're 50 or older) per year, and further limitations may apply according to your income. Visit the IRS to learn more.

SEP (Simplified Employee Pension) IRA

Small business owners and self-employed people can create their own employer-sponsored retirement plans. A simplified employee pension (SEP) IRA allows business owners to contribute significantly more to their retirement funds than they would with a traditional or Roth IRA, though there is a catch if you have employees.

  • Employers can contribute up to 25% of their compensation with a 2021 maximum of $58,000.
  • Each eligible employee must receive the same percentage contribution as the employer: If you make a 25% contribution to your account, you must contribute 25% of each eligible employee's compensation to their IRA account.
  • All contributions come from the employer; employees don't contribute to their own accounts.

Although employers must dig deep to decide whether to fund contributions for each of their employees, self-employed people with no employees often choose a SEP IRA for its generous contribution limits.

SIMPLE (Savings Incentive Match Plan for Employees) IRA

Alternatively, small business owners with up to 100 employees may choose a SIMPLE IRA. A SIMPLE IRA more closely resembles a 401(k) program: Employees choose to contribute their own funds with employer matching. Although contribution limits are higher than they are for standard IRAs, they're substantially lower than for a SEP.

  • Contribute up to 100% of compensation with a maximum of $13,500, or $16,500 if you're age 50 or older.
  • Employers must contribute up to 3% as a matching contribution or 2% as a non-elective employer contribution for eligible employees.

Spousal IRA

Spousal IRAs aren't a specific type of account. Instead, these are traditional or Roth IRAs that use a unique set of IRS rules that let non-working spouses who file jointly with their working spouses contribute even if they don't have qualifying income themselves. If you don't earn money but your spouse does, you may be able to fund your own traditional or Roth IRA.

  • Spouses filing jointly may contribute up to $12,000, $13,000 if one spouse is 50 or older and $14,000 if both spouses are 50 or older.
  • Each spouse must contribute to their own account: You can't contribute jointly to the same IRA.

Non-Deductible IRA

If you want to contribute to an IRA but your income exceeds IRS limits, you can make a non-deductible contribution to your traditional IRA. You do not have to create a special non-deductible IRA account (unless you don't already have an IRA): Non-deductible funds can be commingled with your regular deductible contributions.

  • Report non-deductible contributions to the IRS using form 8606. When you withdraw money in retirement, a portion of your funds won't be taxed, since they were funded by non-deductible contributions.
  • You may be able to make both deductible and non-deductible contributions in the same tax year as long as you follow IRS contribution guidelines.

Self-Directed IRA

Most people set up IRA accounts through a bank, credit union or investment company. These financial institutions follow regulations on the types of investments they're allowed to make, typically including a mix of stocks, bonds, mutual funds and cash.

If you have holdings that don't fit within these IRS guidelines, a self-directed IRA may be for you. This is not a good fit for the vast majority of retirement savers; however, if you're an experienced investor with unusual assets such as real estate, cryptocurrency, precious metals or promissory notes you'd like to hold in an IRA account, look for a financial institution that offers self-directed IRA (SDIRA) accounts, find a trustee to work with, and study up on the requirements and regulations.

What Kind of IRA Should I Open?

For most people, the fundamental choice is between a traditional or Roth IRA. Here, the decision boils down to which benefits you more, a tax deduction now or tax-free distributions in retirement. That could depend on where you are in your career and whether you plan to switch careers to make more or less money. You may also be ineligible for a Roth IRA if you make too much money. If it's hard to know which choice is better for you, consider talking to your tax or financial advisor.

Some of your choices may be decided by circumstance. SEP IRA and SIMPLE accounts are for self-employed people and business owners. Spousal IRAs are for the non-working spouses of people who work. A non-deductible IRA contribution is most useful for people who don't qualify to make a fully deductible IRA or eligible Roth contribution.

Choose to Get Started Now

Remember, too, that you don't have to choose only one type of IRA. You can split your annual contribution between a traditional and a Roth account, for example, or fund different accounts each year. What's most important is that you get started. By opening and funding an IRA, you put yourself on the path to greater retirement security. That's a choice that's easy to make.

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