It is common to see individuals getting to their 40s and freaking out after realizing the time and money they lost by not starting saving for retirement early in their lives. In today’s fast-paced world it is important for investors to be aware of the benefits that opening a retirement account can have in their adult life.
Even though access to these types of tax-advantaged accounts has been relatively easy for many years, it has become as simple as filling an online form with today’s electronic standard. There is no reason not to plan for descent and well-deserved retirement after so many years of hard work.
A common misconception that I usually hear is that individuals believe they have to contribute to the max of the IRA every year and this is not true. Investors can allocate as little as they can, allowing investors to contribute based on their possibilities and with no restriction.
Not two individuals are the same, and this also applies to their retirement accounts. It is important to understand each other personal goals and to plan towards them. There are many different types of IRAs that will boost investments and the possibility of a better retirement in the future. Even though methodologies vary between account types, they all offer a basic standard of tax incentive for investments made through the account.
Bellow, you will find the most important types of IRA account and their most important characteristics. Im confident that there is an IRA that will suit your risk profile and your long term goals perfectly.
What Types of IRAs are there?
Traditional IRAs are the most popular type of account, mostly because it offers a tax-deductible option which allows investors to allocate money pre-tax. In essence, this permits investors to pay for the taxes once they withdraw from the account, taking advantage of their current tax rate. While this might not represent a big deal for in the short-term, it is important for investors to keep in mind that their tax rates will vary as they become older and that in the meantime they will be able to enjoy from the compounding interests in their account.
IRAs provides access for investors to buy stocks, ETFs, bonds, mutual funds, and other liquid asset classes. This type of account especially benefits any individuals who expect to be at a lower tax rate in the future, allowing them to profit from the markets while waiting to pay the tax until they become cheaper later in their life.
- Individuals receive an upfront tax break of up to $6,000 a year ($500 a month)
- Compounded earnings won’t be taxed as long as the money remains in the account
- Withdrawals will be taxed at the tax rate at the time
- Early withdrawals before the age of 59.5 will incur in an extra 10% tax penalty
- After year 70 1/2 investors will have to withdrawal from their account based on a table from the IRS. If they fail to comply with this mandate they will receive a penalty of 50% of the amount they were supposed to withdraw.
- Investors will not be able to do any new contribution after they reach age 70 1/2, but they would be able to invest if they have an exiting ROTH IRA active.
In sinthesis, Roth IRAs offer the same investment properties as Traditional IRAs, but with the opposite tax advantages. Instead of deducting taxes until the withdrawal, investors would pay an upfront tax of their contributions. The rate of the tax would be based on the tax rate at the time.
This allows investors to keep 100% of the returns generated over time, meaning that the tax will only be paid on the money deposited in the account.
Roth IRAs are the perfect option for any individual that anticipates being in a higher tax bracket in the future and decides to save by paying upfront. A key characteristic that it is important to mention is that this type of account is especially attractive for investors that believe they might need cash before retirement age, as they are more lenient with early withdrawals than regular IRAs.
- Max contribution would be $6,000 a year ($500 a month and an extra $1000 over age 50)
- Savings will grow tax-free
- No required minimum distribution
- Investors can contribute after retirement
- Withdrawals do not count as taxable income
- Contributions can be withdrawn with no penalty (earnings are a completely different story)
- Application and contribution will depend on the yearly income of the individual, effectively making non-eligible certain brackets due to their high earnings
- Some cases contribution can be reduced based on your income
- Contributing in excess of the yearly maximum can trigger IRS penalties
Simplified Employee Pension accounts are very similar to Traditional IRAs. The account is funded by the employer, who in return would get tax benefits for the effort. With this model, earnings will grow free of tax, but distributions in retirement will be fully taxed.
One of the key elements that make SEP IRAs so desirable is that they offer a higher contribution limit than any other account. Employers are allowed to contribute up to 25% of the yearly compensation of the employee as long as it stays under $56,000 a year.
Employers should be aware that in order to use this account, the percentage of contribution should be equal to all applicable employees and it does not allow for any contribution via salary deferral.
This model is a great option for small-business owners who are interested in avoiding the cost of starting up and operating a conventional retirement plan, plus to gain access to a tax deduction on any contribution made to their employees.
- That high contribution limit of up to $56,000
- Can be combined with a traditional IRA or a Roth IRA
- Easy to set up and manage
- No external contributions are allowed
- Catchup provisions can’t be done
- Employees should have worked at least 3 to 5 years in order to become eligible
Nondeductible IRAs are funded with after-tax dollars which means that taxes on the capital/contributions has already been paid. Even though they do not offer any tax deduction or exemption, they are the perfect option for any investor looking to defer the tax on their account growth and earnings.
Since the taxes from the capital have been paid before funding, investors will only have to pay based on their earnings and regular capital gains, not the principal.
There are several different guidelines that can make an individual not eligible for a traditional or a Roth IRA; If you find yourself in this category you should consider a Nondeductible account as a healthy and convenient option.
- Capital gains and dividends won’t be taxed until withdrawn
- Provide wealthy individuals with a viable option as none-eligible candidates for a regular IRA
- Backdoor Roth conversion
- Requires a more tight control, it is common to see investors paying taxes by mistake as they don’t have a clear view of their deductible and non-deductible investment
- Long term parking of money carries several risks that include penalties and taxes that could be higher than the income tax that should have been paid in the first instance
The IRS stipulates that in order to be eligible to contribute to an IRA, an individual must have earned income, but there’s a way around for married taxpayers if one of them is not working or if they simply contribute with a very low income. Under this model, a couple can contribute to their own separate IRAs (Traditional, Roth, Non-Deductable).
This is a recommended choice for families with a household income under $112,000 a year, If you exceed this number you won’t be eligible for tax deductions.
- By using this type of account, individuals can easily duplicate their contributing power even if they file a joint tax return
- A working spouse can contribute on behalf of their nonworking partner
- There is not a particular problem or cons associated with Spousal IRAs, but it is worth mentioning that negatives will be based on the type of account (Roth/Traditional)
Simple IRAs are pretty similar to an employer-sponsored 401K or a Sep IRA. The main difference between these two types of accounts is that with simple IRAs individuals can contribute to their account via salary deferral.
From a tax perspective please note that simple IRAs follow the same structure like a Traditional account.
- Equal contribution by the employer to all eligible employees
- Rollover into a traditional IRA after 2 years
- Catchup contributions are allowed
- Simple IRAs can only be implemented at companies with 100 or fewer employees
- Early withdrawals can incur in punishing up to 25%
Self-directed IRAs come in both packages (Roth and Traditional), following most of their rules and their contribution mechanisms. The big difference comes with the type of assets and investment vehicles that you can invest in. This is the only option from this list that drifts away from more traditional investment vehicles like stocks, bonds, and mutual funds and provides access for investors to own assets such as gold, privately held companies, and even real estate.
Even though the name says “Self”, in order to create an account you would require a custodian who specializes in the investment vehicle you are interested in. This person will act as a trustee and will overview the account and the legitimacy of its numbers.
While it represents a new world of opportunities for many investors, it is important to keep in mind that this specific account is not suitable for all individuals, as it requires a higher level of sophistication and experience.
- Access to assets beyond traditional investment vehicles
- Tax Deferred
- Covered by Bankruptcy law
- Hidden Fees and extensive paperwork
- Lack of liquidity
- Thirdparty involvement in management
Best IRA Brokers/Providers for 2019:
Investors should have a clear idea of the type of investment and the account management they are interested in receiving. This is key as services can vary dramatically between brokers. While many Americans rely on asset managers or robo-advisors to manage their portfolio, there are other individuals with the intention to execute their one investments without having to rely on a third party.
For this reason, we are mentioning the best brokers for both hands-on and hands-off investors:
Best IRA Accounts for Hands-On Investors:
Best IRA Accounts for Hands-Off Investors:
Conclusion on Choosing an IRA Account
Individuals should be aware that the best time to start an IRA or any type of retirement account was yesterday! Even if you are starting your professional career it is important to understand that even if small, contributions will build and compound over time. It is incredible to see how the returns of an account can dramatically change over time based on small contributions.
The strongest force in the universe is Compound Interest. Albert Einstein
Starting early will simply boost your savings and your access to a better retirement, it will also take out some of the pressure associated with becoming older without a solid retirement plan.
With such a wide range of options to choose from, it is crucial for investors to think long term with the selection and to also understand deeply the difference between accounts. At the end of the day, the asset classes in most accounts will be the same, they only variable changing will be how the account and any investment will be affected by any type of taxation.
Short term sacrifices will make the difference between a well deserved and financially free retirement, and further economical complications that can result in not been able to retire at all.
Tax advantages will differ between the type of the IRA. In synthesis an IRA will permit an investor to defer their taxes until the money is withdrawn from the account, effectively parking and reinvesting the money.
On the other hand, Roth IRAs will need an upfront payment over the money invested, making any profit made with the capital tax-free.
Please take your time investigating and doing your own research before choosing an IRA account, this is especially important as returns from different account types can vary significantly based on the tax bracket of the owner.
An IRA is relatively not expensive, many brokers offer even better packages for retirement than regular trading accounts, mostly because there is less rotation and money will remain as liquidity for longer periods of time.
While many hands-on brokers will only charge trading fees, other firms offering complete portfolio management can charge up to 1.5% of the account value annually.
Contributions will vary from account type but for Traditional and Roth IRAs there’s a standard maximum contribution of $6,000 a year and an additional extra $1,000 if you are over 50 years old.
If you don’t think that you can contribute to the max there is no problem, any type of investment and contribution made over time will add up towards your retirement. Many brokers allow contributions with no minimum deposits making it accessible for all investors.
After you turn 59 1/2 you can withdraw any amount from your IRA without having to pay the early withdrawal penalty of 10%.
In most cases, IRA Funds can be invested in traditional asset classes like stocks, bonds, ETFs and Mutual Funds. While many investors usually delegate this responsibility to a professional, there are still some that look to manage the funds on their own, based on their risk profile and speculation appetite.
This will depend if you are interested in getting your portfolio managed or if you will manage it on your own. If you don’t have the time or the knoledge I would suggest to go for the VanguardGroup as returns are considered stable and the company is very well known for their portfolio managers.
On the other hand, if you are looking to actively trade your account I recommend to choose between Fidelity and TD Ameritrade, both companies will deliver access to the financial markets in an efficient way. If you are a beginner trader, these two brokers will be especially important for your career as they provide excellent research and educational content that will help improve decision making.