One of the most common forms of saving for retirement is the Individual Retirement Account (IRA). A IRA is a retirement savings account. It may hold different kinds of investments, like cash, mutual funds, bonds, and individual stocks. The money is invested in the account until the contributor reaches retirement age, and the activity within the account (interest and dividends received and capital gains) is not taxed. This allows IRAs to accumulate wealth at a rate that the same investments in a non-retirement account cannot. Approximately 34% of US households own an IRA of one sort or another.
The major difference between different kinds of IRAs has to do with who is contributing to the IRA and when taxes are paid on the IRA.
A traditional IRA is set up by an individual. Contributions may be made with an annual limit of $5500 ($6500 if you are 50 or up), so long as these figures do not equal your taxable compensation for the year. You may also rollover the proceeds of other eligible plans, with a limit of one rollover per year. The contributions are fully tax deductible unless you exceed certain income levels, which vary depending on whether you or your spouse are covered by a retirement plan at work. Distributions are taxed as income, and you are required to begin taking distributions sometime between reaching age 59 ½ and the April 1 of the year following the year you turn 70 ½. You cannot take a loan from an IRA, but you can take an early distribution for certain circumstances, such as higher education expenses or first time home purchase, without penalty. You may also take early distributions that do not meet those circumstances and pay a 10% tax penalty.
A Roth IRA is set up by and individual. Contributions to a Roth IRA are not tax deductible, but distributions are not taxable. Contribution limits are the same as for traditional IRAs, but contributions are limited or disallowed for individuals whose annual gross income exceeds $116,000 or couples whose annual gross income exceeds $183,000. Distributions are not required, but may be made so long as the IRA has been open at least 5 years and you are age 59 ½ or have met another qualifying event.
A Simplified Employee Pension (SEP) IRA is set up by employers, including self-employed individuals and members of partnerships. Tax deductible contributions are made on behalf of the employees and cannot exceed the lessor or 25% of compensation or $53,000. Earnings can include net earnings from self-employment, K-1 partnership income or wages. SEPs are attractive to small businesses because the costs are lower those for 401ks and other business retirement accounts, and because contributions are discretionary.
A Savings Incentive Matching Plan for Employees (SIMPLE) IRA works more like a 401K plan for small businesses (fewer than 100 employees), in that the employee makes contributions to their SIMPLE IRAs and their employer makes either a matching (usually 3% of compensation) or nonelective contribution (2% for all eligible employees regardless of whether they elect to contribute, so long as the employee received at least $5000 in compensation during any 2 preceding calendar years and is expected to receive at least $5000 in the current year), which is mandatory as long as the SIMPLE IRA is maintained. To have a SIMPLE plan, a business cannot have any other type of retirement plan in place. Employee contributions are limited to $12,500 per year, with an additional $3000 catch up contribution for those aged 50 and up. Contributions are 100% vested immediately. Distribution rules are similar to traditional IRAs.
If an individual with an IRA dies, then that IRA is left to their designated heirs. There are different rules for spouses than there are for non-spouses. Spouses may treat an IRA as if it was their own by either designating themselves as owner or rolling it into another IRA plan, or they can act as beneficiaries. Non-spouses do not have this option and must act as beneficiaries, which means they cannot contribute to the IRA or rollover any additional funds to it and there are rules requiring distributions. These rules may require a beneficiary to receive the entire interest in the IRA by the end of the fifth calendar year after the owner’s death, or it may allow the beneficiary to receive the interest in installments based on their life expectancy. Income Taxes are paid on the distribution(s) for the year the they take place, unless the IRA was a Roth.
2015 Investment Company Factbook, Chapter 7, Retirement and Education Savings; Investment Company Institute
Individual Retirement Arrangements (IRA), on IRS Website