An individual retirement account is an investing tool individuals use to earn and earmark funds for retirement savings. There are several types of IRAs as of 2018: traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs. Sometimes referred to as individual retirement arrangements, IRAs can consist of a range of financial products such as stocks, bonds or mutual funds.
Individual taxpayers establish traditional and Roth IRAs, while small-business owners and self-employed individuals establish SEP and SIMPLE IRAs.
In most cases, contributions to traditional IRAs are tax-deductible. For example, if someone contributes $5,500 to his or her IRA, he or she can claim that amount as a deduction on his or her income-tax return, and the Internal Revenue Service will not apply income tax to those earnings. However, when the individual withdraws from the account during retirement, his or her withdrawals are taxed as income. As of 2018, annual individual contributions to traditional IRAs cannot exceed more than $5,500 in most cases. If you are 50 or older, you can contribute up to $6,500 per year.
As of 2018, if you are a single person or file as head of household with a retirement plan available through work and an adjusted gross income of less than $63,000, your IRA contributions are deductible. If you earn more than that amount but less than $$73,000, only a portion of your contributions may be deductible. If your adjusted gross income is more than $73,000, your IRA contributions are not deductible, unless you do not have a retirement plan available through your employer. The IRS has additional rules for people who use another filing status, such as married filing jointly or married filing separately.
Roth IRA contributions are not tax-deductible, but eligible distributions are tax-free. This means you contribute to a Roth IRA with after-tax dollars, but as the account grows, you do not face any taxes on capital gains. When you decide to retire, you can withdraw from the account without incurring any income taxes on your withdrawals.
Self-employed individuals, such as independent contractors, freelancers and small-business owners, can set up SEP IRAs. If a business owner sets up a SEP IRA for his or her employees, he or she can deduct the contributions from his or her reported business income and potentially secure a lower tax rate on his business income. However, his or her employees are not allowed to contribute to their accounts, and the IRS taxes their withdrawals as income.
SIMPLE IRAs or Savings Inventive Match Plans for Employees are also for small businesses and self-employed individuals. Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions too. All the contributions are tax-deductible, potentially pushing the business or employee into a lower tax bracket, which can reduce one's tax bill.
To learn more about saving for retirement, check out What's the difference between an individual retirement account (IRA) and a certificate of deposit (CD)?