What is an IRA and Should I Invest in One?

Traditional IRA

A Traditional IRA is the original IRA that isn’t a Roth IRA or a SIMPLE IRA. It’s a personal retirement savings plan offering tax benefits to encourage retirement savings. Contributions to a Traditional IRA are wholly or partially deductible, based on your income and whether you or your spouse have another retirement plan at work. Your investments in the account compound tax-deferred, meaning you don’t pay taxes on earnings (like interest, dividends, and capital gains) until you withdraw the money.

Withdrawals — both earnings and contributions — are taxed as ordinary income. Additionally, there is a 10% penalty for early withdrawals before age 59½, though there are exceptions. Starting at age 73, as per current laws, you must begin your required minimum distributions (RMDs).

Key Features

• Eligibility:There are no income limits for contributing, but tax deductibility is contingent on income, filing status, and access to employer-sponsored plans.
• Contribution limit: For 2024, the limit is $7,000 plus. For those over 50, a $1,000 catchup contribution is allowed.
• Withdrawals: Taxed as ordinary income upon withdrawal after age 59 ½. Early withdrawals incur a 10% penalty and state and federal taxes.
• RMDs:For individuals born in 1950 or earlier, age 72 or 70½ if you turned 70½ before 2020. And 73 years for individuals born between 1951 and 1959 and 75 years for individuals born in 1960 or later.

Roth IRA

A Roth IRA is a retirement savings plan you contribute to with after-tax dollars. Contributions to a Roth IRA aren’t tax-deductible. However, qualified distributions during retirement are tax-free. Earnings in a Roth IRA grow tax-free, and withdrawals of earnings are also tax-free if the account has been open for at least five years and you are at least 59½ years old.

Roth IRAs do not have mandatory RMDs during the original owner’s lifetime and offer more flexible withdrawal rules than Traditional IRAs. However, income limitations exist for eligibility to contribute to a Roth IRA.

Key Features

• Eligibility: You can contribute if your modified adjusted gross income (MAGI) is less than $161,000 for singles or $240,000 for married joint filers.
• Contribution limit: Same as Traditional IRAs.
• Withdrawals: You can withdraw contributions at any time without penalty. However, for earnings, you must be 59½ years old and held your account for five years to avoid the 10% penalty.
• RMDs:Not subject to RMDs during the owner’s life.

SEP IRA (Simplified Employee Pension)

The SEP IRA is designed for self-employed individuals and small business owners. Under SEP rules, you can contribute to your and each employee’s SEP-IRA. Contributions are made by the employer only and are tax-deductible as a business expense. The main advantage of SEP IRAs is their flexibility. As a business owner, you don’t have to make contributions each year; you can adjust contributions if business conditions are poor.

Key Features

• Eligibility: Any employee over 21 who has worked for you in at least three of the last five years and received over $750 in compensation in 2023 qualifies. The maximum compensation limit is $345,000.
• Contribution limit: Contributions can be up to 25% of compensation or $69,000, whichever is less.
• Withdrawals: Similar to Traditional IRAs for Traditional SEP IRAs. However, for Roth SEP IRAs, you can withdraw contributions at any time without penalties or taxes. However, early earnings withdrawals before age 59½ are subject to a 10% penalty. 
• RMDs: The requirements for traditional SEP IRAs are similar to those for Traditional IRAs. In contrast, Roth SEP IRAs do not require RMDs.
• Tax treatment: Contributions are tax-deductible to the business, and earnings grow tax-deferred.

SIMPLE IRA (Savings Incentive Match Plan for Employees)

A SIMPLE IRA is a small business retirement plan that allows employer and employee contributions. As an employer, you can only set up this option if you had 100 or fewer staff who earned at least $5,000 in compensation in the preceding year. Contributions are from salary reduction contributions to a maximum limit of $16,000 for 2024. In this plan, employers must either match employee contributions up to 3% of the employee’s compensation or make non-elective contributions of 2% of compensation.

Contributions to a SIMPLE IRA are tax-deductible, and the investment earnings grow tax deferred. The tax treatment of withdrawals is like that of a Traditional IRA, but there is an additional penalty for early withdrawal within the first two years of participation.

Key Features

• Eligibility: Any employee who earned $5,000 in compensation in the two preceding calendar years and is likely to receive over $5,000 in the current one can participate.
• Contribution limit: The limit for employees is $16,000. Individuals who are over 50 by the end of the year can make $3,500 in catchup contributions. 
• Withdrawals: Early withdrawals before 59½ years are subject to 10% tax, which is raised to 25% if you withdraw within two years of joining the plan.
• RMDs: Similar to traditional IRAs.
• Tax treatment: Contributions are tax-deductible, and earnings grow tax-deferred.

Rollover IRA

A Rollover IRA is a Traditional or Roth IRA that receives “rolled over” funds from another retirement plan, like a 401(k). You can use it to keep retirement savings tax-deferred when transitioning from one job to another or when changing types of retirement accounts. The tax implications depend on the types of accounts involved; for instance, rolling a 401(k) into a Traditional IRA maintains the tax-deferred status.