IRA plans

An IRA is a valuable retirement plan created by the U.S. government to help workers save for retirement. Individuals can contribute up to $6,000 to an account in 2020, and workers over age 50 can contribute up to $7,000.

There are many kinds of IRAs, including a traditional IRA, Roth IRA, spousal IRA, rollover IRA, SEP IRA and SIMPLE IRA. Here’s what each is and how they differ from one another.

Traditional IRA

A traditional IRA is a tax-advantaged plan that allows you significant tax breaks while you save for retirement. Anyone who earns money by working can contribute to the plan with pre-tax dollars, meaning any contributions are not taxable income. The IRA allows these contributions to grow tax-free until the account holder withdraws them at retirement and they become taxable. Earlier withdrawals may leave the employee subject to additional taxes and penalties.

Pros: A traditional IRA is a very popular account to invest for retirement, because it offers some valuable tax benefits, and it also allows you to purchase an almost-limitless number of investments – stocks, bonds, CDs, real estate and still other things. Perhaps the biggest benefit, though, is that you won’t owe any tax until you withdraw the money at retirement.

Cons: If you need your money from a traditional IRA, it can be costly to remove it, because of taxes and additional penalties. And an IRA requires you to invest the money yourself, whether that’s in a bank or in stocks or bonds or something else entirely. You’ll have to decide where and how you’ll invest the money, even if that’s only to ask an adviser to invest it.

What it means to you: A traditional IRA is one of the best retirement plans around, though if you can get a 401(k) plan with a matching contribution, that’s somewhat better. But if your employer doesn’t offer a defined contribution plan, then a traditional IRA is available to you instead — though the tax deductibility of contributions is eliminated at higher income levels.

Roth IRA

A Roth IRA is a newer take on a traditional IRA, and it offers substantial tax benefits. Contributions to a Roth IRA are made with after-tax money, meaning you’ve paid taxes on money that goes into the account. In exchange, you won’t have to pay tax on any contributions and earnings that come out of the account at retirement.

Pros: The Roth IRA offers several advantages, including the special ability to avoid taxes on all money taken out of the account in retirement, at age 59 ½ or later. The Roth IRA also provides lots of flexibility, because you can often take out contributions – not earnings – at any time without taxes or penalties. This flexibility actually makes the Roth IRA a great retirement plan option.

Cons: As with a traditional IRA, you’ll have full control over the investments made in a Roth IRA. And that means you’ll need to decide how to invest the money or have someone do that job for you. There are income limits for contributing to a Roth IRA, though there’s a back-door way to get money into one.

What it means to you: A Roth IRA is an excellent choice for its huge tax advantages, and it’s an excellent choice if you’re able to grow your earnings for retirement and keep the taxman from touching it again.

Spousal IRA

IRAs are normally reserved for workers who have earned income, but the spousal IRA allows the spouse of a worker with earned income to fund an IRA as well. The working spouse’s taxable income must be more than the contributions made to any IRAs. Your spousal IRA can either be a traditional IRA or a Roth IRA.

Pros: The biggest positive of the spousal IRA is that it allows a non-working spouse to take advantage of an IRA’s various benefits, either the traditional or Roth version.

Cons: There’s not a particular downside to a spousal IRA, though like all IRAs, you’ll have to decide how to invest the money.

What it means to you: The spousal IRA allows you to take care of your spouse’s retirement planning without forcing your partner to have earned income as would usually be the case. That may allow your spouse to stay home or take care of other family needs.

Rollover IRA

A rollover IRA is created when you move a retirement account such as a 401(k) or IRA to a new IRA account. You “roll” the money from one account to the rollover IRA, and can still take advantage of the tax benefits of an IRA. You can establish a rollover IRA at any institution that allows you to do so, and the rollover IRA can be either a traditional IRA or a Roth IRA. There’s no limit to the amount of money that can be transferred into a rollover IRA.

A rollover IRA also allows you to change the type of retirement account, from a traditional IRA to a Roth IRA, or vice versa. You’ll create a rollover IRA account to move the money into and then make the transfer. Certain types of transfers can create tax liabilities, however, so it’s important to understand these consequences before you decide how to proceed.

Pros: A rollover IRA allows you to continue to take advantage of attractive tax benefits, if you decide to leave a former employer’s 401(k) plan for whatever reason. If you simply want to change IRA providers for an existing IRA, you can roll over your account to a new provider. As in all IRAs, you can buy a wide variety of investments.

Cons: Like all IRAs, you’ll need to decide how to invest the money, and that may cause problems for some people. You should pay special attention to any tax consequences for rolling over your money, because they can be substantial, but this is generally only an issue if you’re changing your account type.

What it means to you: A rollover IRA is a convenient way to move from a 401(k) or an IRA to another IRA account. The rollover IRA may be able to improve your financial situation by offering you a chance to change IRA types from traditional to Roth or vice versa.

SEP IRA

The SEP IRA is set up like a traditional IRA, but for small business owners and their employees. Only the employer can contribute to this plan, and contributions go into a SEP IRA for each employee rather than a trust fund. Self-employed individuals can also set up a SEP IRA.

Contribution limits in 2020 are 25 percent of compensation or $57,000, whichever is less. Figuring out contribution limits for self-employed individuals is a bit more complicated.

“It’s very similar to a profit-sharing plan,” says Littell, because contributions can be made at the discretion of the employer.

Pros: For employees, this is a freebie retirement account. For self-employed individuals, the higher contribution limits make them much more attractive than a regular IRA.

Cons: There’s no certainty about how much employees will accumulate in this plan. Also, the money is more easily accessible. This can be viewed as more good than bad, but Littell views it as bad.

What it means to you: Account holders are still tasked with making investment decisions. Resist the temptation to break open the account early. If you tap the money before age 59 ½, you’ll likely have to pay a 10 percent penalty on top of income tax.

SIMPLE IRA

With 401(k) plans, employers have to pass several non-discrimination tests each year to make sure that highly compensated workers aren’t contributing too much to the plan relative to the rank and file.

The SIMPLE IRA bypasses those requirements because the same benefits are provided to all employees. The employer has a choice of whether to contribute a 3 percent match or make a 2 percent non-elective contribution even if the employee saves nothing in his or her own SIMPLE IRA.

Pros: Littell says most SIMPLE IRAs are designed to provide a match, so they provide an opportunity for workers to make pre-tax salary deferrals and receive a matching contribution. To the employee, this plan doesn’t look much different from a 401(k) plan.

Cons: The employee contribution is limited to $13,500 for 2020, compared to $19,500 for other defined contribution plans. But most people don’t contribute that much anyway, says Littell.

What it means for you: As with other DC plans, employees have the same decisions to make: how much to contribute and how to invest the money.