A Side-By-Side Comparison of Different IRA Types
An individual retirement account (IRA) is intended to be a tool for people to save for retirement while also leveraging tax benefits, including tax-free growth. Being strategic about how you invest your money within your IRA could be a gamechanger for your retirement security and lifestyle, and it could make the difference if unexpected emergencies occur.
Being strategic can entail the choices you make about what you purchase in your IRA. You may opt for a conventional IRA with a major financial institution, where you will select from a relatively limited range of investment options like mutual funds, stocks, and bonds. Or, you may lean into diversifying your retirement savings by opening a self-directed IRA, which gives you the widest number of investment options that IRS requirements allow for.
But being strategic can also involve choosing what type of IRA you open. To make this selection, it can be helpful to understand how the different types of retirement accounts operate, how the various types differ, and how to actually set one up or roll funds into one that fits your life.
The four most common types of IRA are:
- Traditional IRAs – We’ve seen this one named the “elder statesman of IRAs”, and it’s offered by a large number of financial institutions. Traditional IRAs offer tax-deferred contributions from your annual income, tax-sheltered trading within accounts, and even tax deductions for contributions under most circumstances.
- Roth IRAs – Very similar to Traditional IRAs in the choice of providers and assets to store your savings, a Roth IRA centers around a fundamental difference: instead of tax-deferred contributions, distributions aren’t taxed in retirement. Pay your taxes upfront and be done with them, assuming you follow the schedule to receive your distributions.
- SEP IRAs – Simplified Employee Pension (SEP) IRAs offer higher contribution limits for freelancers and small business owners. They are easy to set up and offer the same tax-deferred and tax-deductible contributions as Traditional IRAs.
- SIMPLE IRAs – Savings Incentive Match Plan for Employees (SIMPLE) IRAs are best suited to businesses with less than 100 employees. They offer the same tax treatment as Traditional and SEP IRAs, but require mandatory employer-matched contributions.
This is a high-level summary of the four major types of IRA, but there are further distinctions to be drawn between these types. If you are choosing to open an IRA or deciding whether or not to opt into one that’s being offered to you, these distinctions are important.
We’ll focus our attention on highlighting the three main elements needed for a big-picture understanding of the IRA types: eligibility, contribution guidelines, and tax responsibility.
In order to open and contribute to one of these four types of IRAs, you’ll need to meet some eligibility criteria. There can be significant differences between these IRAs that make some types a better fit for you than others.
As you can see in the chart below, some IRAs have more stringent criteria than others.
|Most viable type for…||Anyone||Anyone*||Small business owners with fewer than 100 employees||Small business owners with no or few employees|
|You can sign up (or contribute) to a plan if…||You have taxable compensation||You have taxable compensation*||•Been with company last two years|
•At least $5,000 of compensation
|•Ages 21 and older|
•At least $600 of compensation
•Employer has the right to invoke “3 of 5” rule
|You can roll funds from…**||All major retirement accounts except Roth||All major retirement accounts||All major retirement accounts except Roth after first two years||All major retirement accounts except Roth|
|*Contributions are reduced after certain income thresholds. See IRS page here for more.|
|**See IRS Rollover Chart for more|
Traditional and Roth IRAs are designed for individuals exclusively to start and contribute to, while SEP and SIMPLE IRAs incorporate employer contributions—which can accommodate a wide range of employment situations, including the self-employed as well as sole proprietors.
According to the IRS, SIMPLE IRAs are designed to avoid the start-up and maintenance costs that can come with other employer-sponsored retirement plans such as a 401(k). As a result, SIMPLE IRAs are often favored by small businesses with under a hundred employees. On the other hand, if you are a freelancer or self-proprietor, you might opt for a SEP IRA for reasons we will cover in the next two sections.
A potentially tricky part of SEP eligibility is that an employer can invoke the “3-of-5” eligibility rule, which adds a requirement that employees must have worked with the employer for three of the past five years. This effectively becomes a workaround for employers who want to offer a retirement benefit to their employees, but perhaps are not yet in a position where they can afford to match everyone’s contributions.
When we examine IRA contribution limits, we see a similar trend as with eligibility. While Traditional and Roth accounts are very similar in their rules, SEP and SIMPLE IRAs come with more varied guidelines.
|Each tax year, you can contribute up to…||$6,000||$6,000*||The lesser of:|
•25% of compensation
|$13,500 (2020) or $13,000 (2019)|
|If over 50, you can contribute an additional…||$1,000||$1,000*||$0||$3,000|
|*Contribution limits do go down, and eventually hit $0 depending on modified adjusted gross income. See below.|
Traditional IRAs and Roth IRAs show no significant differences in terms of contributions, but they allow individuals to start up their own retirement savings and choose between deducting contributions and deferring taxes (Traditional) or paying taxes upfront (Roth).
By far, SEP IRAs offer the highest ceiling on compensation. If you are self-employed with adequate income, you can rapidly catch up on your retirement savings from this kind of plan.
SEP IRAs require employers to contribute an equal percentage of contribution to their employees’ accounts as they put into their own. For example, if a small business owner has two employees and decides to put 8% of her annual income into her SEP account, she will also have to put 8% of what each employee makes into theirs.
SIMPLE IRAs are similar but have a bit more complexity. The employer must either:
- Match up to 3% of employees’ compensation, or
- Contribute a fixed 2% of their compensation even if they don’t contribute themselves.
So, while there is a mandatory employer contribution to employees’ accounts, it is capped compared to SEP IRAs.
Roth IRAs stand out from all the other types in a couple of significant ways. First, all contributions to a Roth IRA are after-tax; we’ll get into that in a bit more detail in the next section. Second, Roth IRAs have contribution limits based on each person’s modified adjusted gross income. Up until a certain modified adjusted gross income (MAGI) and depending on your tax filing status, your contribution maxes out at $6,000 (or $7,000 if you’re at least 50 years old). If you make more than that the cut-off, the amount you can contribute is lowered; past a certain point, you cannot contribute at all.
But even if you make too much to contribute to a Roth, you can still open one through what’s called a “backdoor Roth IRA.” The way this works is that first you open a Traditional IRA, roll those funds into a new Roth IRA, and pay taxes on that rollover. From there, you won’t be able to contribute more; but you’ve already paid your tax bill and can enjoy tax-free distributions in retirement.
For 2019 taxes, single tax filers with income between $122,000 and $137,000 can contribute a reduced amount to their Roth IRAs. If their income is more than that, they can’t contribute at all.
For 2020 taxes, these income caps go up slightly. For single filers, the income range for reduced contribution limits is between $124,000 and $139,000. There’s a similar increase for other types of tax filers.
IRA Tax Obligations
The tax obligations you face with each type of IRA will vary slightly. With some, the taxes are due up front; with others, taxes are only paid on distributions. But the tax situation is even more complex than that, with different deadlines for both opening and contributing to these accounts.
|Contributions are…||Tax deferred and deductible1||Made with after-tax income||Tax deferred and deductible1||Tax deferred and deductible1|
|Distributions after age 59 1/2 are…||Taxed as ordinary income||Tax-free||Taxed as ordinary income||Taxed as ordinary income|
|Withdrawals prior to age 59 1/2 are…||Usually subject to 10% penalty plus taxes||Usually subject to 10% penalty, but tax free2,3||Usually subject to 10% penalty plus taxes||Usually subject to 10% penalty plus taxes; 25% in first two years of opening it|
|Deadline for opening an account||Tax Day|
(for previous calendar year)
(for previous calendar year)
|The employer’s tax filing date, usually Tax Day||October 15 of first tax year|
|Deadline for contributions||Tax Day|
(for previous calendar year)
(for previous calendar year)
|Tax Day, or October 15 with a tax extension||December 31 of that tax year|
|*Generally, April 15; in 2021 for 2020 returns, this was extended to May 17.|
1Contributions to these plans count against deduction limit if you also have an employer-sponsored plan, such as a 401(k).
|2If distributions are made from earnings, they are also subject to a capital gains tax.|
3A Roth account must have been open for 5 years and owner must be 59 ½ older to withdraw without a penalty; it does not need to be the account from which the withdrawal is made.
As you can see, each of the accounts vary slightly on things like deadlines and early withdrawal penalties. The major outlier type of IRA is the Roth.
A Roth IRA’s main draw is its tax-free distribution. You do have to pay taxes on the income used to contribute, but after that you are tax-free. If your tax bracket goes up between those contributions and when you begin taking distributions, you’ll have potentially saved money by frontloading your tax bill.
Now, that does leave less money in the account to build between contributions and distributions, which is worth bearing in mind. Reviewing this in the context of your financial situation with a professional is going to be your best bet in making the right decision for your retirement.
Considering the higher contribution limits of an SEP, the longer contribution deadline can be particularly helpful. This longer timeline gives you the most flexibility to maximize both contributions and deductions in any given year.
SIMPLE IRAs have the strictest deadlines and early withdrawal penalties if deductions are made in the first two year; but, as seen above, they do have higher contribution and “catch-up contribution” limits than some of the other common types.
How to Choose Which IRA Type Is Right for You
As you can see, all of these IRA types offer certain tax advantages; and the way contributions, distributions, and even early-withdrawal penalties work can differ greatly by type. Just to review, here are the key standout features of each IRA type:
- Traditional IRAs – Contributions are tax-deferred and tax-deductible; they work well with businesses of any size. And they offer reasonable deadlines each tax year—right up until Tax Day.
- Roth IRAs – Considering that what sets a Roth IRA apart from other IRAs is that the tax benefits associated with contributions and distributions are reversed–contributions are made with after-tax money and distributions are what’s tax-free—this type of IRA is often recommended if you expect to be in a higher tax-bracket in your retirement years than in your contributing years. These are also subject to certain income requirements that may limit their usefulness depending on your situation.
- SEP IRAs – These are designed for freelancers and businesses with one or more employees. The strict employer-matching contribution requirements might not make these are a good choice if you employ many others.
- SIMPLE IRAs – These are great for small businesses, in that they allow slightly higher contribution levels, but cap employer-matched contributions. So, if you are looking for a slightly larger annual contribution than a Traditional IRA and you have some employees, this might be the way to go.
These IRA types are available not just for conventional IRAs, which offer a more limited range of asset types that may be purchased (such as mutual funds, bonds, and stocks), but also for self-directed IRAs (SDIRAs).
An SDIRA offers the widest selection of asset types that may be purchased, and so these IRAs can play an essential role when pursuing diversification as part of your retirement strategy.
Assets like cryptocurrency can be purchased and held tax-free in an SDIRA, known as a Digital IRA. A Digital Currency Specialist can walk you through setting up your Digital IRA, and they’re just a phone call away at (800) 299-1567.