When it comes to your retirement, it’s never a bad idea to maximize your savings as early as possible. By investing early and consistently, you’ll be at a huge advantage for securing a comfortable retirement.
An IRA is part of any solid retirement savings strategy. Though you may be contributing to a retirement plan at work, having an IRA allows you another tax-efficient method of saving for retirement. And if you have multiple retirement accounts, you can consolidate all your retirement assets into an IRA.
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What is an IRA?
An Individual Retirement Account, or IRA, is a tax-advantaged retirement savings account. Unlike employer-sponsored accounts like 401(k)s, IRAs are opened by individual investors.
Upon opening an IRA, you can invest your funds into stocks, exchange-traded funds, and mutual funds. You can also use your IRA to supplement any of your employer-sponsored retirement plans, which unlocks a potentially wider range of investment options.
There are various types of IRAs including Traditional, Roth, SEP, SIMPLE, and Rollover. Each has different requirements, conditions, and unique benefits.
Depending on the type of IRA, you benefit from one of two huge tax perks:
- Tax-deferred growth so you can postpone taxes until you withdraw your money from your account, and
- Tax-free growth so you won’t owe taxes on your investment earnings at all
In exchange for these tax benefits, there are certain restrictions, such as contribution limits and an early withdrawal penalty.
An IRA can include savings from several different sources. In addition to contributing directly, you can also roll over contributions from 401(k)s and other employer-sponsored retirement plans.
Whether you choose a Traditional, Roth, SEP, or SIMPLE IRA, the tax benefits allow your savings to compound at a much faster rate than in a taxable account. If you need to save for living expenses, travel plans, and passion projects in retirement, having an IRA is a no-brainer.
Here are the basics on five types of IRAs.
- Traditional IRA. An IRA to which you contribute pre-tax dollars, and which allows your money to grow tax-deferred. Withdrawals made after age 59½ are taxed as income. Anyone at any income level can contribute to a Traditional IRA. It’s best for those who are in a higher tax bracket now than they think they’ll be during retirement.
- Roth IRA. An IRA that allows you to set aside after-tax income up to a specified amount each year. Withdrawals are generally tax- and penalty-free after 5 years and after age 59½. However, there are income eligibility limitations. It’s best for those who anticipate being in a higher tax bracket in retirement.
- SEP IRA Plan. A Simplified Employee Pension IRA (SEP IRA) is used by business owners to provide retirement benefits for the business owners and their employees. It’s best for small business owners who want higher contribution limits and to avoid the high startup and administrative costs of a conventional retirement plan.
- SIMPLE IRA Plan. A Savings Incentive Match PLan for Employees IRA may be established by employers, including self-employed individuals. A SIMPLE IRA allows eligible employees to contribute part of their pre-tax compensation to the plan. This means the tax on the money is deferred until it’s distributed. It’s best for smaller companies with fewer than 100 employees.
- Rollover IRA. An account that allows you to move funds from your old employer-sponsored retirement plan into an IRA. A Rollover IRA generally has greater flexibility and lower fees than a 401(k). You aren’t subjected to taxes or withdrawal penalties at the time of transfer, and funds can continue to grow with tax-favorable treatment. It’s best for those who want to consolidate former employer plans and gain access to more investment options.
How Does an IRA Work?
Investments held in IRAs can encompass a range of financial products, including stocks, bonds, ETFs, and mutual funds.
Because IRAs are intended to help you save for retirement, you’ll pay an early-withdrawal penalty of 10 percent if you withdraw from your accounts before age 59½. Depending on the type of IRA you have, you may also be required to pay income tax on your early withdrawal.
As an individual taxpayer, you can establish Traditional, Roth, and Rollover IRAs.
Employers can open SEP IRAs and SIMPLE IRAs.
Individual Taxpayers: Traditional vs. Roth IRA
Depending on your income and whether you/your spouse are covered by an employer-sponsored retirement plan, such as a 401(k)
You must start taking required minimum distributions (RMDs) at age 72
No RMDs; you’re not required to withdraw any money at any age, at all
Annual contribution limits in 2021*
*You may contribute earned income which includes wages, salaries, tips, bonuses, commissions, and self-employment income. It doesn’t include alimony, child support, rental property income, interest and dividends from investments, pay you received from an inmate in a penal institution, retirement income, Social Security, or unemployment benefits.
Small Business Owners and Self-Employed Individuals: SEP vs. SIMPLE IRA
Fewer than 100 employees
Who can contribute
Employers and employees
Annual contribution requirements
Flexible; employers can adjust contributions depending on company’s cash flow
Employers can match up to 3% of the employee’s annual contribution, or set up a non-elective 2% contribution of each employee’s salary
Annual contribution limits in 2021
Employers can contribute up to $57,000 or 25% of the employee’s compensation, whichever is less
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Why Do I Need an IRA?
If you plan on retiring, you’re going to need income to support your post-work lifestyle. Financial experts estimate that most Americans will need around 85 percent of their pre-retirement income in retirement—and even more if you have big plans for travel, leisure, or legacy. Having money in an IRA is a way to make that happen.
An IRA gives you a long list of benefits:
- Supplement your current savings. Employer-sponsored retirement accounts have annual contribution limits, so adding an IRA is another way to save for your golden years.
- Widen your investment options. An IRA gives you access to a bigger menu of investment choices and greater flexibility than your employer-sponsored plan.
- Manage your tax bill. The biggest advantage of any IRA is potential tax-deferred or tax-free growth.
- Enjoy greater control and consolidation. Your IRA belongs to you, so you have the ultimate say in how and when you want to make contributions. It isn’t tied to your employer, and it sticks with you through retirement. You can transfer other retirement accounts into your IRA so all your retirement savings are in one account.
- Have greater clarity. With all your retirement accounts in one place, your overall retirement situation will be easier to assess and adjust. It’ll be easier to determine whether your assets are properly diversified or if they should be reallocated at any given time.
Opening an IRA could be one of the smartest moves you make toward planning for your retirement. It’s a practical way to augment your retirement savings alongside a company retirement plan, and it offers a broader set of investment opportunities that may otherwise be unavailable to you.
What is the Best Place to Open an IRA?
An IRA must be opened with an IRS-approved institution, such as a bank, brokerage company, federally insured credit union, or Registered Investment Advisory firm.
Most individual investors open IRAs with brokers. However, when it comes to financial matters, it’s safest to go with a Registered Investment Advisor. Why? You might be surprised to learn that not all banks, brokers, or financial advisors are required to act in the best interest of their client.
If you’re looking for sound, unbiased investment advice, consider a financial institution that has the Fiduciary duty to put your interests first: a Registered Investment Advisor.
As a Registered Investment Advisory firm, we are regulated by the Securities and Exchange Commission, or the SEC. That means we have a fundamental obligation to act in your best interest.
You’ll receive full transparency when we help you create your unique financial and investment plan. Our investment recommendations are based on what’s best for you.
Types of IRAs
Traditional and Roth IRAs are two of the most widely used individual retirement savings vehicles. The lesser-known SEP and SIMPLE IRAs offer tax-saving, money-growing benefits for employers. You can also take advantage of IRA Rollovers to consolidate all your retirement assets and access better investment options.
A Traditional IRA is a tax-deferred retirement savings account with no income cap. No matter how much you make or contribute, all of your investment gains can compound each year, tax-free. This allows your IRA to grow much faster than a taxable account.
There are two kinds of Traditional IRAs: deductible and nondeductible. Whether you qualify for a full or partial tax deduction depends mostly on your income and whether you have access to an employer-sponsored retirement account, such as a 401(k). In general, if you (and your spouse) don’t have a retirement plan at work, you’ll be able to take a full deduction for your contribution.
You do defer taxes over the life of your IRA, but at a certain point Uncle Sam wants his cut. You’ll pay income taxes on your distribution. However, if you think you’ll be in a lower tax bracket than during your earning years, you’ll benefit from paying a lower tax rate on your IRA distributions.
For 2021, the individual contribution limit is $6,000 per year. If you are 50 or older, you can contribute up to $7,000 annually thanks to catch-up contributions. Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA.
Per the 2019 SECURE Act, by age 72, you must begin taking required minimum distributions (RMDs) based on your account size and life expectancy. Failure to do so may result in a tax penalty amounting to 50% of the amount of the RMD.
A Roth IRA allows for tax-free savings and distributions. Your contributions aren’t tax-deductible, but in return for funding your Roth with after-tax dollars, your investments grow tax-free. When you withdraw at retirement, you get to keep all your investment gains.
You can have a Roth IRA even if you’re covered by a retirement plan at work. And you can contribute to a Roth IRA as long as you have eligible earned income, no matter your age.
The Roth comes with some flexibility regarding withdrawals. You can take out your contributions anytime, but you can’t withdraw earnings without penalty for five years—unless you have a qualified exception, such as a first-time home purchase.
Roth IRAs don’t have RMDs. If you don’t need to withdraw money, you don’t have to take anything out of your account. This feature means that Roth IRAs are ideal wealth-transfer vehicles.
For 2020, the individual contribution limit is the same as for traditional IRAs, or $6,000 per year. Again, if you are 50 or older, you can contribute up to $7,000 annually using catch-up contributions.
However, single filers making more than $139,000 (and joint filers making above $206,000) are restricted from contributing to a Roth IRA. To circumvent the income limitation, you can use a Backdoor Roth.
Backdoor Roth IRAs
A Backdoor Roth is an alternative way to take advantage of Roth benefits if you exceed the income limits. In short, you can open a Traditional IRA and convert it to a Roth IRA.
It’s optimal if your Traditional IRA accounts consist entirely of nondeductible contributions. If not, you’ll need to return that tax deduction. When it comes time to file your tax return, be prepared to pay income tax on the money you converted to a Roth. And if the money in your Traditional IRA has accrued investment gains, you’ll also owe taxes on those gains.
Setting Up Your Backdoor Roth IRA
Types of Transfers
The conversion must take place one of three ways:
- A rollover. You receive the money from your Traditional IRA, then deposit it into your Roth IRA within 60 days.
- A trustee-to-trustee transfer. The IRA provider sends the money directly to your Roth IRA provider.
- A “same trustee transfer.” Your money goes from the IRA to the Roth at the same financial institution.
The pro rata rule
The IRS permits Traditional IRAs to roll over into Roth IRAs on a pro rata, or proportionate allocation, basis.
When determining your tax bill on a conversion from Traditional to Roth, the IRS will assess all your Traditional IRAs together.
Let’s say that all of your Traditional IRAs consist of 85% pre-tax funds and 15% after-tax funds; that will become the proportion of your money that is taxable upon conversion. The IRS applies the pro rata rule to your total IRA balance not at the time of conversion, but rather at year-end.
A Simplified Employee Pension, or SEP IRA, is a type of group retirement plan. Employers can establish SEP IRA plans, then make contributions to a Traditional IRA set up within the SEP IRA.
SEP IRA plans are popular among small business owners and self-employed individuals because they allow for higher contribution limits than Traditional and Roth IRAs. In general, employees can’t contribute to a SEP, and you’ll face a premature withdrawal tax penalty of 10%.
In most other aspects, SEP IRA rules are similar to those of Traditional IRAs. Your contributions are made with pre-tax dollars, your withdrawals are taxed as ordinary income, and early distributions are penalized.
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is another type of group retirement plan. Unlike SEP IRAs, SIMPLE IRAs allow you to contribute pre-tax dollars with matching contributions from your employer. Your contributions are tax-deductible, which could potentially push you into a lower tax bracket.
In 2020, you can contribute up to $13,500. If you’re over age 50, your catch-up limit is $3,000.
A SIMPLE IRA also follows the same taxation rules for withdrawals as a Traditional IRA. Distributions are subject to ordinary income tax, and there are early-withdrawal penalties.
A Rollover refers to the transfer of money from one retirement savings vehicle to another. When done correctly, a Rollover can safeguard your retirement funds against tax withholdings.
You might want to make a Rollover for any number of reasons. Perhaps you want to switch investments. Maybe you’ve received death benefits from your spouse’s retirement plan. Or maybe your employment situation has changed. In many cases, a Rollover IRA is the best way to handle old IRAs and 401(k)s.
If you’re leaving a job, you generally have three options:
Leave your plan as is.
This isn’t ideal.
You won’t be able to easily contact HR for questions or concerns, and you may be charged higher 401(k) fees as an ex-employee.
Cash out your IRA.
This is an even worse option. Why?
You’ll have to cough up a 10 percent early withdrawal fee on top of ordinary income taxes on the amount distributed.
That translates to 40 percent wiped out of your company-sponsored nest egg.
Do an IRA Rollover.
That leaves the last choice: you can roll over either into your current employer’s retirement plan or into an IRA.
Rolling into an IRA is generally the better option because unlike a 401(k), which can have fewer investment options and higher administrative fees, an IRA gives you a wide variety of investment options and comparatively lower fees.
Now, an IRA Rollover can take place in one of three possible ways:
- Direct rollover. A Direct Rollover is the tax-free movement of retirement funds from one type of retirement account directly into a different type of retirement account. For example, you can roll over your 401(k) or 403(b) into an IRA. Your plan administrator will draft a check or wire transfer made out to your new account custodian.
- Trustee-to-trustee transfer. A trustee-to-trustee transfer happens between like accounts. For example, a Traditional IRA can transfer to another Traditional IRA. If you’re getting a distribution from an IRA, you can ask the financial institution holding your IRA to make the payment directly from one IRA to another IRA. Since the money is never in your hands, the IRS has no right to charge any penalties or taxes.
- 60-day rollover. If you’re receiving a distribution from an IRA or other retirement plan, you can deposit all or some of it into an IRA or another retirement plan. The rollover must be completed within 60 days of the date that your distributions are granted—otherwise, all or part of your distribution may be taxed and subject to a stiff 10 percent early distribution penalty.
Finally, the following types of plans allow Rollovers:
- Traditional IRA
- Employer’s qualified retirement plan for employees
- Section 457(b) eligible governmental plan
- Section 403(b) plan
- Roth IRA (very limited)
- Designated Roth account within a plan (also limited)
IRA One-Rollover-Per-Year Rule
The IRS doesn’t allow you to make more than one Rollover from the same IRA within any 12-month period, no matter how many IRAs you own.
The one-per-year limit doesn’t apply to:
- Rollovers from Traditional IRAs to Roth IRAs (conversions)
- Trustee-to-trustee transfers to another IRA
- IRA-to-plan Rollovers
- Plan-to-IRA Rollovers
- Plan-to-plan Rollovers
If you receive a distribution from an IRA of previously untaxed amounts, you must include the amounts in gross income if you made an IRA-to-IRA Rollover in the preceding 12 months. Moreover, you’ll have to pay the 10 percent early withdrawal tax on the amounts that you include in gross income.
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Pros and cons of an IRA rollover
Which IRA is Best For Me?
The IRA that you choose will depend on a few different things:
- Your employment status
- Your income
- Your workplace benefits
- How much you want to contribute
- Whether you plan to withdraw before your designated retirement age
The two most popular types of IRAs are Traditional and Roth. The main difference between them is their tax treatment:
- Traditional IRA. You can deduct your contributions as they’re going into your account, but you’ll have to pay taxes on distributions in retirement. If you do a 401(k) Rollover, you won’t pay any taxes on the rolled-over amount until retirement.
- Roth IRA. You make contributions with after-tax money, so your withdrawals and gains are tax-free after age 59½. You’ll have to pay taxes on the rolled amount, unless you’re rolling over to a Roth 401(k).
Stick with a Traditional IRA if you need to use cash from the Rollover to foot the tax bill today. A Roth IRA will only open you up to more tax complications.
We Can Help
If you have big plans for retirement, you’ll likely need more than just your employer-sponsored savings plan to fund your retirement vision.
Taking action today is the first step toward securing the prosperous retirement that you’ve always dreamt of. Our Fiduciary Advisors can help you explore the many investment opportunities that an IRA has to offer, as well as tax-minimizing strategies so you'll have more control over your financial future.
We'll support you in your retirement planning process by guiding you toward better, more well-informed choices and adapting your retirement plan as needed.
If you would like to learn more about doing an IRA Rollover with Prosperity Financial Group, please fill out the form below and we'll get back to you shortly. We look forward to hearing from you.
DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.