IRAs, Roth IRAs and 401(k)s
What are they? How can they help me?
Brief History of IRAs –
Up until 1981, individuals had few government-structured options to help save or invest for retirement. To address this problem, Congress created the Individual Retirement Arrangements Act as part of the 1974 “Employee Retirement Income Security Act” also called ERISA. This was updated in 1981 to allow individuals to directly contribute to their accounts. Today, when we refer to the common term “IRA” we mean the account allowed under the 1981 Employee Retirement Income Security Act. The Employee Retirement Income Security Act allows individuals to open an “IRA” account. These types of accounts are opened to contain one or more types of investments. These can contain mutual funds, stocks, bonds, annuities, and exchange-traded funds (ETFs). Over the years, additional types of IRAs have been created which allow far more flexibility on what can be part of the portfolio. Current IRA and 401(k) options are detailed below.
Since 1981, the various Federally mandated retirement plans have been very successful and have grown from the Traditional IRA to many new plans that allow the investor to get a tax benefit while investing toward their retirement.
Key to the value of these plans is how the investor is able to save with some level of tax benefit. This tax benefit is intended to increase the investor’s savings by reducing the tax burden, this is on the front-end with the Traditional IRA or the back-end as with the Roth plans. More is explained about this in later paragraphs.
The two most well know types of retirement accounts are IRA and 401(k). The difference between them is an IRA can be opened by any individual while the 401(k) is an employer-provided plan.
How can these plans help me achieve a better retirement?
Regardless of which of these plans you choose to open, or participate in at your workplace, they all provide some type of tax benefit. This has the potential of either allowing you to increase the amount you are able to invest into your plan by allowing you to divert funds that would normally be included in your income tax and place those funds into the plan. We know the more one can invest earlier, the greater potential for increased growth within the retirement plan. With a Traditional IRA, once you retire and receive distributions, you are taxed on the amount of the distribution. This is called tax-deferred.
The other type of investment plan is the Roth IRA or Roth 401(k). These have no tax deferral on the front end, but allow you to pay taxes on the monies you invest with the tax benefit on the back end as distributions from the plan are tax-free.
There are more details further down this section.
Know your IRAs and 401(k)s – A quick overview –
Investment plans set up by the individual:
The original investment option focused on conservative retirement portfolios. It features tax-deferred contributions meaning you don’t pay tax on your contributions, but pay taxes when you take distributions. Anyone can open a Traditional IRA. <click for Traditional IRA details>
Like the traditional IRA, the Roth allows for a conservative investment portfolio but it differs from the Traditional IRA as taxes are NOT deferred so there is no deduction on your taxes for any contributions you make today, but the financial value is at the “back end” as distributions (withdrawals) from the Roth IRA account are tax-free. <click for Roth IRA details>
Similar to the traditional IRA and Roth IRA, the Self-Directed IRA (SDIRA) can be a Roth SDIRA or a Traditional IRA SDIRA. The SDIRA allows you to have tax benefits as either a Traditional or Roth IRA, but the SDIRA differs on what kind of investments are allowed. Generally, the SDIRA allows investments in a wider range and a less conservative portfolio. <click for Self-Directed IRA details>
Employee Retirement Savings Plans:
This IRA is provided by a small business of 100 employees or less and employers will contribute to the plan and also allow the employees to contribute to their own plan. <click for Simple IRA details>
Like the Simple IRA, this is an employer-provided plan but differs from the Simple IRA in two ways, any size business can establish one of these for their employees and fund the plan, but the employee can not contribute to their retirement account. < click for SEP IRA details >
This is the best-known employer-provided plan. Similar to a Traditional IRA as the distributions (withdrawals) are taxable at retirement, < click for 401(k) details >
A SIMPLE IRA plan (Savings Incentive Match PLan for Employees) allows employees and employers to contribute to Traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan. < click for Simple 401(k) details >
Very similar to a 401(k), the 403(b) is only allowed to be provided by employers that are 501c(3) non-profit organizations, public schools, healthcare cooperatives, religious organizations, and other related non-profits. < click for 403(b) details >
What can and cannot be held in an IRA and a Self-directed IRA
Before continuing to the details of each type of account, it is important to know that not all accounts can hold every possible type of investment. The general rule is most IRAs and similar 401(k)s can hold similar types of investments, with IRAs having a little more flexibility. However, the Self-Directed IRA has a wider range of investment options. It is important to know what can be held in each type of IRA account as this will help you decide which fits your investment goals.
Here’s what you can and cannot hold in each:
Traditional and Roth IRA:
- Mutual funds
- Exchange-traded funds (ETFs)
- Certificates of deposit (CDs)
- Money market funds
- Life insurance
- Collectibles (like artwork, antiques, gems, coins, and alcoholic beverages)
- Certain types of precious metals
Can hold (in addition to the traditional assets):
- Real estate (residential, commercial properties, raw land, trust deeds)
- Private placements (private equity, venture capital, hedge funds)
- Limited partnerships
- Tax lien certificates
- Certain types of precious metals
- Certain types of coins
- Certain types of cryptocurrency (like Bitcoin)
- Life insurance
- Any investment that constitutes a “prohibited transaction” (like buying property for personal use)
With a self-directed IRA, you have more investment options, but these also come with more responsibilities and potential risks. Self-directed IRAs require more active management and understanding of the investments you’re making. Additionally, there are strict IRS rules about what constitutes a “prohibited transaction” and violating these rules can lead to severe tax penalties.
Before making any decisions, it’s recommended to consult with a financial advisor or tax professional to ensure you understand the rules and potential tax implications.
Detailed explanations of these types of accounts –
Individual Retirement Accounts:
The Traditional IRA –
How can an IRA account help with my retirement?
The Traditional IRA can increase your investment (contribution) by allowing you to use some of the money you would have paid in taxes to be put into your investment account. After you retire you then pay the taxes on the withdrawals from the account. Once retired, you are expected to be in a lower tax bracket so any withdrawals should incur less taxes.
A more detailed explanation –
When you open the usual investment account, a bank savings account for instance, you make deposits, earn interest and then pay taxes on that interest. The money you deposited in the bank was taxed, also called “after taxes” and was part of your gross adjusted income. (IRS info on GAI) This means that other than a few exemptions, such as student loans, you have paid taxes on the money you deposited in your bank savings account. Additionally, you will also pay taxes on any interest earned in that account.
The Traditional IRA benefits –
The benefit of a Traditional IRA is any money deposited (referred to as a “contribution”) made into your Traditional IRA account can, within certain limits, be deducted from your tax return. It is key to understand the value of this benefit. Since the money you invest, or save, grows over time, the more you are able to invest now will have the greater potential for higher future returns. With a traditional IRA, you are able to “shield” some of your income from being taxed in the year that you make a contribution to your traditional IRA account, so you are able to invest more of your income, which can result in the potential of greater growth over time as you have invested more money earlier. More invested earlier is better.
A simple example of how the Traditional IRA helps you invest more, earlier
For instance, when you make a contribution of $1,000 into your IRA, you are allowed to reduce your taxable base (the amount you are taxed by the IRS) by $1,000. A Traditional IRA “contribution” is considered a “tax deduction”. So, if you earned a salary of $60,000 and you made a $1,000 contribution to your IRA account, you will only pay taxes on $59,000. This helps you invest in your future by using some of the money you would have paid in taxes for investing toward retirement.
The Traditional IRA account allows you to shield the money you invest from being taxed “today”, but when you withdraw from your IRA in the future, you then pay taxes on that money and its growth. This is what “tax-deferred” means. The benefit of tax deferral is that most people will be in a lower tax bracket in retirement than when they were working, so you will pay less tax on the money you withdraw (referred to as a distribution).
For 2023, the maximum annual contribution limit is $6,500 and if you are 50 or older, the limit is $7,500. If you, or your spouse, has a retirement plan at work, your maximum contribution limit may be reduced.
One important item is the requirement to take an annual distribution from your Traditional IRA account starting in April of the year you reach 72. This is called the Required Minimum Distribution (RMD). This means after you turn 72, you must start taking distributions from the Traditional IRA account. If you want to leave monies to your spouse or children, it may not be possible with a Traditional IRA as you may live long enough to exhaust any balance in the account after taking the RMDs. If leaving a legacy is your goal, then a Roth IRA should be considered.
The IRS provides a formula to calculate your RMD. The calculation is basically formulated so that your IRA account will have a zero balance at the end of your expected lifetime. For example, using the IRS table in 2023, if you turned 72 this year, you would take the current value of your traditional IRA account and divide it by 17.2 (your expected remaining lifetime). Therefore, if you have $75,000 in your IRA account, you would divide $75,000 by 17.2 for an RMD of $6,148 for 2023. The actual RMD is usually provided by the institution that is managing your IRA account.
Here are some key aspects of Traditional IRAs:
- Contributions: Individuals can make contributions to a Traditional IRA up to a certain limit each year. As of 2023, the limit is $6,500, or $7,500 for those aged 50 or over.
- Tax Deductibility: Contributions to a Traditional IRA may be fully or partially tax-deductible, depending on your income and whether you or your spouse have access to a workplace retirement plan.
- Tax-Deferred Growth: Investments in a Traditional IRA grow tax-deferred. This means you don’t pay taxes on the account’s earnings until you take withdrawals in retirement.
- Withdrawals: Withdrawals from a Traditional IRA are taxed as ordinary income. Withdrawals can begin at age 59 ½ without penalty, although they can be made earlier with a 10% penalty unless an exception applies.
- Required Minimum Distributions (RMDs): Starting at age 72, owners of Traditional IRAs must start taking required minimum distributions (RMDs) each year based on their life expectancy.
- Eligibility: Anyone with earned income can contribute to a Traditional IRA, up to the annual limit. There are no income limits for contributions, but there are income limits for determining the tax deductibility of those contributions.
- Investment Options: Traditional IRAs can be invested in a wide range of assets, including stocks, bonds, mutual funds, ETFs, and more, depending on the options provided by the IRA custodian.
The Roth IRA –
One difference between a Roth IRA compared to a Traditional IRA is where the tax benefit is taken. Remember that contributions to a “traditional” IRA are tax-deferred meaning you are allowed to deduct the amount of the contributions from your taxable income thereby lowering your taxable income for the year you made the contributions, but will be taxed upon distributions (withdrawals) of the retirement funds. The Roth IRA switches the tax benefit from the front end to the back end. You get no tax deduction for your contributions going into your Roth IRA account, but after you retire and begin to withdraw from the Roth IRA account, all monies are considered tax-free.
The other difference is the Roth IRA does not have Required Minimum Distributions (RMDs) meaning there are no requirements to take distributions from the investment account. If you don’t need the funds, you are free to leave them grow in the account.
Why choose the Roth IRA rather than the Traditional IRA?
– Do you expect to have a larger tax burden when you retire? This could make a Roth IRA a logical choice.
If you plan to have substantial growth in the future and expect to have few deductions to offset the income, then a Roth IRA makes good sense because all the distributions (withdrawals) are tax-free, as long as you stay within the rules. The rules are that you must wait until you are 59 ½ to withdraw and you must leave the investments in the account for 5 years. However, there are exceptions and they are withdrawing money for a first-time home purchase, college, birth, or adoption.
– Do you like the idea of not being required to empty your IRA account?
Roth IRAs do not have the RMDs (Required Minimum Distributions) of the traditional IRA, so you can leave the funds to grow as long as you wish.
Here are some key aspects of Roth IRAs:
- Contributions: Contributions to a Roth IRA are made with after-tax dollars, so they are not tax-deductible. As of 2023, the contribution limit is $6,500 per year, or $7,500 for those aged 50 or over.
- Tax-Free Growth: Investments in a Roth IRA grow tax-free. This means you won’t owe taxes on the account’s earnings, provided you meet certain conditions for tax-free withdrawal.
- Tax-Free Withdrawals: Withdrawals from a Roth IRA are tax-free in retirement, as long as the account has been open for at least five years and you are at least 59 ½ years old.
- No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not require minimum distributions during the owner’s lifetime, allowing the funds to continue growing tax-free.
- Eligibility: Not everyone can contribute to a Roth IRA. Eligibility to contribute is phased out at certain income levels, which vary depending on your tax filing status.
- Early Withdrawals: You can withdraw the contributions (but not the earnings) from a Roth IRA at any time without tax or penalty, making it more flexible than a traditional IRA in terms of access to your funds.
- Investment Options: Roth IRAs can be invested in a wide range of assets, including stocks, bonds, mutual funds, ETFs, and more, depending on the options provided by the IRA custodian.
NOTE: IRA accounts can hold certain types of investments. For a list of what can and can not be held in Traditional, Roth, and SEP IRAs, click here
Self-Directed IRA or Self-Directed ROTH IRA –
A self-directed Individual Retirement Account (SDIRA) is a type of IRA that allows investors to direct their investments into a broader range of assets compared to traditional IRAs.
Traditional and Roth IRAs are typically limited to stocks, bonds, and mutual funds and these are accepted as “conservative” investments. However, a self-directed IRA provides more investment options, such as real estate, private company stock, limited partnerships, tax lien certificates, and more.
The rules and tax benefits apply to whether you choose a SDIRA that is a Traditional or Roth type.
Here are some key features of self-directed IRAs:
- Control: With a self-directed IRA, investors have more control over their investment decisions. They can diversify their portfolio by investing in non-traditional assets, which can potentially offer higher returns, or losses.
- Broad Choice of Investments: SDIRAs allow investments in a broad range of assets, including real estate, precious metals, private mortgages, private company stock, oil and gas limited partnerships, etc. <see full list below >
- Tax Benefits: Like other IRAs, self-directed IRAs offer significant tax advantages. Traditional self-directed IRAs provide tax-deductible contributions and tax-deferred growth, while Roth self-directed IRAs offer tax-free growth and tax-free withdrawals in retirement.
- Risk and Reward: While SDIRAs offer a broader range of investment options, these investments can also carry higher risk. It’s important to thoroughly research any potential investment and consider seeking advice from a financial advisor.
- Prohibited Transactions and Disqualified Persons: The IRS prohibits certain transactions within self-directed IRAs and disallows investments involving “disqualified persons”. This includes the IRA owner, their spouse, their ancestors and lineal descendants, and any spouses of lineal descendants.
- Custodian Role: Self-directed IRAs require an IRS-approved custodian to hold the IRA assets and handle all the paperwork. However, it’s important to note that the custodian does not provide investment advice.
The types of investments that can be held in a self-directed IRA include:
- Real Estate: This includes residential properties, commercial real estate, raw land, rental properties, and more.
- Private Company Stocks: SDIRAs can hold shares in privately held companies.
- Limited Partnerships and Limited Liability Companies: These types of business structures can be part of an SDIRA.
- Precious Metals: Certain types of gold, silver, platinum, and palladium can be included, provided they meet specific purity requirements.
- Private Mortgages and Notes: You can lend money through your SDIRA and receive interest payments in return.
- Tax Lien Certificates: When property owners fail to pay their taxes, some states sell tax lien certificates to investors. These can be held in a self-directed IRA.
- Crowdfunded Ventures: SDIRAs can be used to invest in crowdfunded businesses or real estate projects.
- Cryptocurrency: Some SDIRA custodians allow for cryptocurrency investments, like Bitcoin.
- Commodities: Certain types of commodities, like oil and gas, can be held in an SDIRA.
- Hedge Funds and Private Equity: Some SDIRAs allow investment in these types of advanced, high-risk investment vehicles.
Note: It is important to know that the IRS still imposes certain restrictions on SDIRA investments. For instance, life insurance and collectibles are prohibited, and there are rules against self-dealing (using IRA assets for personal benefit). Because of the complex rules and potential for severe tax penalties, it’s crucial to seek professional guidance when setting up and managing a self-directed IRA.
Employer-sponsored Retirement Accounts:
SIMPLE IRA –
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a type of tax-deferred retirement plan that smaller businesses (with 100 or fewer employees) and self-employed individuals can set up for their employees. SIMPLE IRAs are easier to set up and run than most other types of employer-sponsored retirement plans, making them a popular choice for small businesses.
Here are some key points about SIMPLE IRAs:
- Contributions: Both employees and employers can contribute to a SIMPLE IRA. Employees can make salary deferral contributions, and employers can make either matching contributions (up to 3% of an employee’s compensation) or non-elective contributions (a flat 2% of an employee’s compensation for all eligible employees, whether they contribute or not).
- Contribution Limits: The contribution limit for employees in 2023 is $15,500, with an additional $3,500 catch-up contribution allowed for those aged 50 or over. These limits are lower than those for 401(k)s, but higher than those for traditional or Roth IRAs.
- Immediate Vesting: All contributions to a SIMPLE IRA are immediately 100% vested, meaning the employee has full ownership of the funds.
- Eligibility: Employees who received at least $5,000 in compensation during any two preceding years and are expected to receive at least $5,000 during the current year are eligible for a SIMPLE IRA.
- Withdrawals and Distributions: Withdrawal rules for SIMPLE IRAs are similar to those for traditional IRAs. Withdrawals can begin at age 59 ½ without penalty. Withdrawals before this age are subject to a 10% early withdrawal penalty unless certain conditions are met. However, this penalty increases to 25% if the withdrawal occurs within the first two years of participation in the SIMPLE IRA plan. Required minimum distributions (RMDs) must begin at age 72.5.
- Taxation: Contributions to a SIMPLE IRA are tax-deductible, and investment growth is tax-deferred. Distributions in retirement are taxed as ordinary income.
SEP IRA –
A Simplified Employee Pension (SEP) IRA is a type of retirement savings plan established by employers, including self-employed individuals, for the benefit of their employees. SEP IRAs are a popular choice among small business owners due to their simplicity, flexibility, and high contribution limits.
Here are some key points about SEP IRAs:
- Contributions: Unlike traditional IRAs and Roth IRAs, only employers can contribute to a SEP IRA. Contributions are tax-deductible for the business, and they grow tax-deferred in the employee’s account until withdrawal.
- High Contribution Limits: SEP IRAs have significantly higher annual contribution limits than traditional or Roth IRAs. In 2023, employers can contribute up to 25% of an employee’s compensation or $66,000, whichever is less.
- Flexibility: Employers aren’t required to contribute every year, making SEP IRAs a good choice for businesses with fluctuating profits. However, when contributions are made, they must be made equally (as a percentage of compensation) for all eligible employees.
- Eligibility: Employees are eligible for a SEP IRA if they are at least 21 years old, have worked for the employer in at least three of the last five years, and have received a minimum level of compensation from the employer (at least $750 in 2023).
- Simplicity: SEP IRAs are easier to set up and administer than many other types of employer-sponsored retirement plans. There are no filing requirements for the employer, and employees manage their own accounts.
- Withdrawals and Distributions: The same rules apply as with traditional IRAs. Withdrawals can begin at age 59 ½ without penalty. Withdrawals before this age are subject to a 10% early withdrawal penalty, with certain exceptions. Required minimum distributions (RMDs) must begin at age 72.
- Rollovers: SEP IRA funds can be rolled over into other types of IRAs or retirement plans.
The best known of the employer-sponsored retirement plan. It is similar to the Traditional IRA regarding being tax-deferred as contributions made to the 401(k) reduce your taxable income for the years they are made and only taxed when distributions are withdrawn. And also like the Trditional IRA, when you reach 72, you must take Required Minimum Distributions (RMDs). As the 401(k) is setup by the employer so if the organization does not have a 401(k), you can still establish a Traditional or roth IRA on your own.
Here are some key aspects of 401(k) plans:
- Contributions: Employees can elect to defer a portion of their salary to their 401(k) account, which reduces their taxable income for the year. The IRS sets a limit on these contributions. For 2023, the limit is $22,500, or $30,000 for those aged 50 or over.
- Employer Match: Many employers offer to match a portion of their employees’ contributions, effectively increasing the amount saved. The specifics of the match vary by employer.
- Tax-Deferred Growth: The investments in a 401(k) grow tax-deferred. This means you won’t pay taxes on the account’s earnings until you withdraw the money in retirement.
- Withdrawals: Withdrawals from a 401(k) are taxed as ordinary income. You can start making penalty-free withdrawals at age 59 ½. Withdrawals made before this age are generally subject to a 10% early withdrawal penalty unless an exception applies.
- Required Minimum Distributions (RMDs): Starting at age 72, you must start taking required minimum distributions (RMDs) from your 401(k) each year, based on your life expectancy.
- Investment Options: 401(k) plans typically offer a range of investment options, such as mutual funds, target-date funds, and sometimes company stock. The specific options depend on the plan offered by your employer.
- Roth 401(k): Some employers offer a Roth 401(k) option, which is funded with after-tax dollars. While contributions aren’t tax-deductible, both the investment growth and withdrawals in retirement are tax-free, provided certain conditions are met.
SIMPLE 401(k) –
A SIMPLE (Savings Incentive Match Plan for Employees) 401(k) is a retirement savings plan designed for small businesses with 100 or fewer employees. It’s a less complex version of a traditional 401(k), with fewer administrative responsibilities, making it a popular choice for small businesses.
Here are some key points about the SIMPLE 401(k):
- Contributions: Both employees and employers can contribute to a SIMPLE 401(k). Employees can make salary deferral contributions, and employers are required to make either matching contributions (up to 3% of an employee’s compensation) or non-elective contributions (a flat 2% of an employee’s compensation for all eligible employees, whether they contribute or not).
- Contribution Limits: The contribution limit for employees in 2023 is $15,500, with an additional $3,500 catch-up contribution allowed for those aged 50 or over. These limits are lower than those for traditional 401(k)s.
- Immediate Vesting: All contributions to a SIMPLE 401(k) are immediately 100% vested, meaning the employee has full ownership of the funds.
- Eligibility: Employees who have earned at least $5,000 in compensation during the preceding year and are expected to earn at least $5,000 in the current year are eligible for a SIMPLE 401(k).
- Withdrawals and Distributions: Withdrawal rules for SIMPLE 401(k)s are similar to those for traditional 401(k)s. Withdrawals can begin at age 59 ½ without penalty. Withdrawals before this age are subject to a 10% early withdrawal penalty, unless certain conditions are met. Required minimum distributions (RMDs) must begin at age 72.
- Loan Feature: Unlike SIMPLE IRAs, SIMPLE 401(k) plans can allow loans, providing more financial flexibility for employees.
- Taxation: Contributions to a SIMPLE 401(k) are tax-deductible, and investment growth is tax-deferred. Distributions in retirement are taxed as ordinary income.
A 403(b) plan is a type of tax-sheltered retirement savings plan for specific employees of public schools, tax-exempt organizations, and certain ministers.
Here are some key aspects of 403(b) plans:
- Contributions: Employees can elect to defer a portion of their salary to their 403(b) account, reducing their taxable income for the year. The IRS sets a limit on these contributions. For 2023, the limit is $22,500, or $30,000 for those aged 50 or over.
- Employer Contributions: Some employers also contribute to the 403(b) plan, often through a matching program similar to a 401(k) plan.
- Tax-Deferred Growth: The investments in a 403(b) grow tax-deferred, meaning you won’t pay taxes on the account’s earnings until you withdraw the money in retirement.
- Withdrawals: Withdrawals from a 403(b) are taxed as ordinary income. You can start making penalty-free withdrawals at age 59 ½. Withdrawals made before this age are generally subject to a 10% early withdrawal penalty unless an exception applies.
- Required Minimum Distributions (RMDs): Starting at age 72, you must start taking required minimum distributions (RMDs) from your 403(b) each year, based on your life expectancy.
- Investment Options: 403(b) plans typically offer annuity contracts through insurance companies or custodial accounts invested in mutual funds. The specific options depend on the plan offered by your employer.
- Roth 403(b): Some employers offer a Roth 403(b) option, which is funded with after-tax dollars. While contributions aren’t tax-deductible, both the investment growth and withdrawals in retirement are tax-free, provided certain conditions are met.