Roth, SEP, or traditional? When it comes to IRAs (individual retirement accounts), do you have a tough time keeping the differences straight? Don’t worry: You’re not the only one.
The three types of IRAs serve different purposes, and each come with their own set of benefits and potential drawbacks. While all offer the ability of helping you save for retirement, there are fundamental characteristics of each that impact your retirement planning. What’s more, your eligibility to use certain IRAs will be based on your income level and access to employer-sponsored retirement plans.
Here, we’ll provide a high level look at the ins and outs of each type, so you can make a more informed decision about which IRA is right for you.
The Benefits: This IRA comes with an upfront tax break. When you contribute to a traditional IRA, you contribute pre-tax money, which has the effect of reducing your taxable income. Those funds grow tax-free as long as you leave the money in the account.
You can also take a tax deduction for your contributions, as long as your income falls below a certain threshold.
Potential Drawbacks: Traditional IRAs aren’t completely tax free, of course — just tax-deferred. When you withdraw money (usually in retirement), it will be taxed at your income tax rate at the time. It’s also important to know that you can’t leave money in a traditional IRA to grow tax-deferred indefinitely. Starting at age 72, you’ll be required to take required minimum distributions (RMDs) each year. The RMD amount will be computed using an age-based formula.
How much money you put into a traditional IRA is capped at $6,000 a year (that limit is new for 2020). If you’re over 50, you can add a $1,000 catch-up contribution, for a maximum annual contribution of $7,000.
One more thing: If you or your spouse have a workplace retirement plan (such as a 401(k) or SEP IRA), eligibility to make tax-deductible traditional IRA contributions is based on the amount of your modified adjusted gross income (MAGI).
The Benefits: SEP stands for simplified employee pension. It’s a way that small businesses and even self-employed individuals can establish retirement plans for themselves and their employees, when they otherwise wouldn’t have the option. Employers can deduct contributions to a SEP IRA from their taxes, and for employees, the contributions made by their employer are immediately vested.
The SEP comes with less cost and complexity than 401(k) plans, making them an attractive option for small business owners and their employees. Employers can also change how much they contribute year-by-year.
This type of IRA comes with higher contribution limits than either a Roth or traditional: up to 25% of your compensation, capped at a $57,000 contribution.
Potential Drawbacks: SEP IRAs are treated just like traditional IRAs for tax purposes. This means that any withdrawals in retirement from a SEP IRA will be taxed as ordinary income. There are RMDs here, too, the same as those for a traditional IRA. Barring any exceptions, if you withdraw funds before age 59½, you’ll be subject to an additional 10% tax.
Not all employers and employees are eligible for participation in a SEP IRA, and there are certain income limits (the 2020 eligible compensation limit is $285,000). Catch-up contributions for those 50 and older aren’t available in a SEP IRA.
The Benefits: The tax break on a Roth IRA comes later, when you withdraw funds tax-free from your account. There are zero RMDs for a Roth, so you aren’t required to withdraw the funds if you don’t need them for income.
Another benefit to the Roth is the ability to create a spousal Roth IRA on behalf of your married partner who earns little to no income.
Potential Drawbacks: When it comes to taxes, there’s no up-front deduction on a Roth IRA. You invest funds in a Roth IRA post-tax.
Roth IRAs have certain eligibility requirements, and you can never contribute more to your Roth IRA than you make in a single year. If your modified adjusted gross income (MAGI) is above a certain amount, you aren’t eligible to contribute at all to a Roth. If you are a joint filer, that income limit is $206,000, and for single filers, the limit is $139,000 for 2020. If you make more than $196,000 as a joint filer or more than $124,000 as a single filer, your allowable contribution will also be reduced.
In terms of other eligibility requirements, you aren’t able to qualify to fund a Roth IRA based upon certain types of unearned income. These include rental income, interest income, pension or annuity income, and stock dividends and capital gains. Only earned income and money related to a divorce (like alimony and child support) is eligible for contribution.
Have questions about which retirement account is best for you, or are you a small business owner interested in learning more about retirement plans? Ironwood Wealth Management is here to help. Contact us today.