An individual retirement account is an investing tool used by individuals 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.
Traditional and Roth IRAs are established by individual taxpayers, while SEP and SIMPLE IRAs are retirement plans established by small business owners and self-employed individuals.
In most cases, contributions to traditional IRAs are tax deductible. For example, if someone contributes $5,500 to his IRA, he can claim that amount as a deduction on his income tax return, and the Internal Revenue Service does not apply income tax to those earnings. However, when the individual withdraws from the account during retirement, his withdrawals are taxed as income. As of 2018, annual individual contributions to traditional IRAs cannot exceed more than $5,500, or $6,500 if you are 50 or older.
If you have a retirement plan available through work and you earn less than $63,000 for an individual as of 2018, your IRA contributions are deductible, but if you earn over that amount, 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 head of household.
Roth IRA contributions are not tax-deductible. However, 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, and when you 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 employees, he can deduct the contributions from his reported business income and potentially secure a lower tax rate on his business income. However, his employees are not allowed to contribute to their accounts, and when they make withdraws from their accounts during retirement, the withdrawals are taxed as income.
SIMPLE IRAs or Savings Inventive Match Plans for Employees are also for small businesses and self-employed individuals. However, unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions to their accounts, and the employer is required to make contributions. All the contributions are tax deductible, potentially pushing the business or employee into a lower tax bracket, a helpful way to 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)?