An IRA (Individual Retirement Account) is a tax-advantaged way to help you save for retirement. Exactly what those advantages are depends on the type of IRA you choose. It’s important to understand that an IRA is a type of account, not an investment. Almost any stock, bond, mutual fund, savings account or certificate of deposit can be set up as an IRA. Your earnings will be determined by the type of investment you select to put inside your IRA account, while the tax-treatment of those earnings will be determined by the type of IRA you select. We’ll expand more on that below.
What are the different types of IRA’s?
Traditional IRA’s are available to anyone with earned income and, as of tax year 2020 and beyond, of any age. The earnings on traditional IRA’s are always tax-deferred and contributions may be tax-deductible based on your income. Upon distribution at retirement (after age 59 ½), all deductible contributions and earnings are subject to ordinary income tax. If taken before age 59 ½, a 10% penalty tax may apply.
Roth IRA’s are available to those whose income falls below certain levels and the earnings are also tax-deferred. The difference is that contributions to a Roth IRA are never deductible for current tax-year purposes. Because you pay taxes on the contributions going in, qualified distributions from a Roth IRA are not taxable at the time of distribution, making these an attractive way to generate tax-free income at retirement.
Rollover IRA’s are basically traditional IRA’s that are used for the very specific purpose of moving funds out of an old employer-sponsored retirement plan. By following a specific process to move the funds, you can preserve the tax-deferred status of your retirement assets without paying current taxes or early withdrawal penalties. By designating the account as a Rollover IRA, you may also be able to move those funds into a future employer’s plan.
Spousal IRA’s allow non-working spouses of wage earners to contribute to an IRA based on the working spouse’s income.
Other types of IRA’s such as SIMPLE IRA’s or SEP-IRA’s either originate from, or are available through, a person’s employer much like a 401k or 403b plan.
What investments can I use to fund my IRA?
Again, almost any stock, bond, mutual fund, savings account or certificate of deposit can be set up as an IRA, but the investment is not the IRA itself. Rather, the investment is held inside the IRA account. Think of it this way: An IRA account acts like a cup that you can put any beverage you want into – coffee, tea, water – whatever. If you don’t like the beverage (i.e. – the investment) in the cup (i.e. -the IRA account), you don’t have to close the account, you simply need to dump the beverage (sell the investment) and put a new beverage (a new investment) in the same account.
It’s important to understand this because different fees, penalties and taxes can be applied to either the account or the investment, and sometimes both. Too often people make the mistake of closing an account because they don’t like the performance of the investment that is inside that account. In doing so, they often incur withdrawal penalties, taxes or tax penalties. It’s like tossing out a very expensive china cup because you don’t like the tea that was served. Just dump the investment and fill the account with a new investment more to your liking.
For help in determining which type of IRA might be right for you, call (805) 988-2151 ext. 5710 or complete the form on this page to request an appointment with one of our advisors.
The information presented here is for educational purposes only and should not be considered financial, tax or investment advice. Please consult a qualified professional.
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