How To Select The Right IRA

Selecting the right Individual Retirement Account (IRA) can be a daunting task for some, especially when it feels like there are endless options to choose from.

But an IRA is worth doing a bit of homework for. These investment vehicles can be a great way to build wealth for retirement while offering flexibility and tax savings, and, importantly, are available even if you don’t have access to a company retirement plan through your workplace.

In March of 2020, the U.S. Department of Labor reported that only 67% of Americans had access to a retirement plan through their workplace. In contrast, many IRAs are easily accessible to most people and can be set up in minutes through a brokerage firm or your financial advisor.

But why is selecting the right IRA so critical for most individuals? And how are IRAs better than a typical savings account?

How an IRA Might Work for You

Tax benefits are one of the biggest incentives to opening an IRA. These benefits are similar to those of many employer-sponsored retirement plans, such as 401(k)s or 403(b)s. If you have access to a company-sponsored retirement plan, it’s a good idea to invest in it as well as an IRA (if allowed): diversification is as important with retirement strategies as with investments themselves, and besides, you might be able to get an employer match through your workplace.

Additionally, an IRA can provide financial security to augment any current retirement savings you may have.

A recent study published by the National Institute on Retirement Security found that 40% of Older Americans rely solely on Social Security for retirement income. That might not be enough.

How to Choose the Right IRA for Your Needs

Although they can all be helpful under the right circumstances, there are many different types of IRAs — and choosing the right one is important for the health and prosperity of your nest egg.

Here are some of the most common types of IRAs available, and which circumstances might mean they’re right for you.

Traditional IRA

A Traditional IRA is an account that allows you to make contributions on pre-tax dollars, giving you an immediate tax benefit: the money you contribute to the account is tax-deductible the year you do so. Your money can then grow tax-deferred, but later, you will pay ordinary income tax on your withdrawals. In addition, you must start taking distributions from your Traditional IRA after age 72, or 70 1/2 for those who turned 70 1/2 in 2019 or earlier.

To contribute and receive the full tax deduction on your Traditional IRA for 2021, a single person must earn under $66,000, and a married person must make under $105,000. This year’s contribution cap is $6,000, plus an additional $1,000 if you’re age 50 or older.

Keep in mind that contributions are optional — and even if you make more than those income thresholds, there are still good reasons to consider this type of account. Although most individuals would like to benefit from the tax deduction, you’ll still defer taxes on investment earnings with non-deductible IRA contributions. This strategy really shines when you’re not eligible for any other retirement accounts. Just remember, the non-deductible Traditional IRA has its own eligibility and contribution rules, and you must keep track of contributions.

Another common reason to establish a Traditional IRA is to roll over assets from another retirement account (either an employer-sponsored account or IRA) and keep deferring taxation on contributions and earnings. This type of Traditional IRA is called a Rollover IRA — but they work the same, from a tax perspective.

Lastly, due to the fact that you’ll be paying your taxes later as opposed to up front, a Traditional IRA is a great choice for individuals who expect to be in a lower tax bracket in the future.

Roth IRA

In lieu of the current-year tax deduction that the Traditional IRA offers, with a Roth IRA, you contribute after-tax dollars. But when you take distributions from your Roth IRA down the line, both the contributions and earnings are withdrawn tax-free.

To maintain the tax-free eligibility, you must have owned the Roth IRA for a minimum of five years and have reached age 59½ or older. You or your beneficiaries may also be able to make tax-free distributions earlier if you’re disabled, deceased, or buying your first home (though the five-year rule still stands).

Otherwise, your earnings (but not contributions, since you’ve already paid taxes on them) are subject to ordinary income tax, as well as the 10% early withdrawal penalty.

The annual contribution limits for a Roth IRA in 2021 are $6,000 per year if you are 50 or younger, and $7,000 for those 50 and above. And unlike Traditional IRAs, Roth IRAs are not subject to mandatory distribution requirements, which makes them useful vehicles for passing on an inheritance.

There are some limitations to who is able to open a Roth IRA. In 2021, If you are single and make more than $125,000, or you are married (filing taxes jointly) and make more than $198,000, you will either be limited in your contributions, or not eligible to contribute at all.

A Roth IRA is typically a good account for those who believe their tax bracket will be higher in retirement, who plan on retiring prior to age 59 ½ (since you can withdraw contributions penalty-free), or for those who want to leave a tax-free inheritance to heirs.

Self-Directed IRA

If you want to expand your investment choices within an IRA beyond traditional stocks and bonds, then a self-directed IRA might be right for you.

Self-directed IRAs allow you to buy alternative investments that typical IRA trustees or custodians would otherwise prohibit. Examples include real estate, raw land, crowdfunding, private debt or equity, public offerings, gold, precious metals, and even cryptocurrency.

Please keep in mind that this type of IRA is not for novice investors. You are responsible for selecting and managing your investments within the self-directed IRA. The custodians holding the IRA are not allowed to give you financial advice, and each firm has a different menu of investment offerings.

Additionally, self-directed IRAs can come with higher fees, and it may be more difficult or time-consuming to liquidate or transfer alternative assets.

Small Business IRAs

If you’re a business owner, you can sponsor an IRA-based plan to help both you and your employees contribute towards retirement. For most of these plans, businesses can get a tax deduction for their contributions and the costs of establishing the plan.

SEP IRA

The Simplified Employee Pension Plan (SEP) is an IRA that allows only the employer, not the employee, to contribute. Under a SEP IRA, employer contributions are optional, but should the owner contribute to their plan, they must contribute to all eligible employee’s plans.

The maximum total annual contribution (again, to which only the employer can contribute) is the lesser of 25% of an employee’s compensation (20% of the business owner’s net earnings) or $58,000, for 2021. Traditional IRA taxation applies once the money is withdrawn from this plan.

SIMPLE IRA

A Savings Investment Match Plan for Employees (SIMPLE) IRA is another one that’s all about the employer contribution — though employees are also able to defer wages into the account. As the sponsor of the plan, you can choose between matching 1%-3%, dollar for dollar, of employee contributions, or contributing a flat 2% non-elective contribution for all eligible employees, regardless of whether they contribute or not. This type of IRA is limited to companies with less than 100 employees, who must each have earned $5,000 or more in the preceding year.

The SIMPLE IRA contribution limit for 2021 is $13,500, and an additional $3,000 if the employee is age 50 or over.

Unlike the fact that a person can have both a Traditional and Roth IRA, you can only choose one or the other between a SIMPLE and SEP IRA.

Lastly, SIMPLE IRA account holders are subject to some different rules than those who own other types of IRAs. For instance, you must wait at least two years after your initial contribution to a SIMPLE IRA to combine it with another individual or employer retirement plan, and early distributions are penalized at a whopping 25%, rather than the 10% penalty other IRAs receive.

Solo 401(k)

A solo 401(k), otherwise known as a one-participant plan, is meant to be used solely by a business owner with no employees. Contributions can be made either before (Traditional) or after (Roth) tax. The contribution limit for 2021 is $19,500, with an additional $6,500 catch-up contribution if you’re age 50 or older.

There are no age or income restrictions on solo 401(k)s. You can open one as long as you have an EIN, and the IRS will make an exception to their “no-employees” rule for solo 401(k) owners if the employee in question is your spouse. The IRS will require an annual report on Form 5500-SF if the solo 401(k) plan has $250,000 or more in assets at the end of any given year, so keep in mind you may have to file some additional paperwork.

There are benefits to each different IRA you can choose from. However, it’s essential to make sure you explore all of your options as you plan for your retirement. Felton and Peel would love to be of assistance as you weigh your options in considering different types of IRA plans, and we can help you choose the one that’s best for you and your retirement goals.

Malik S. Lee, CFP®, CAP®, APMA®
Malik Lee is the Managing Principal of Felton & Peel Wealth Management. A CERTIFIED FINANCIAL PLANNER™ with more than 15 years of financial services experience, he is a Guest Lecturer at Morehouse College, serves on the CFP Board Council of Examinations, and is a Board Member for the FPA of GA.
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