Investing in your future is one of the main goals of personal finance, especially when it comes to a person’s retirement portfolio. One of the ways to reach your financial goals can be done with an Individual Retirement Account, known as an IRA. But what exactly is an IRA, how does it help you with retirement, and how does it differ from a retirement portfolio? An IRA is a type of retirement account that is with an institution and is considered part of your overall portfolio with all the other investments. The main advantage of an IRA is that it is an investment account that is tax-deferred before or after retirement, depending on the plan.
When it comes to IRAs, there are two main types that are widely used and two that are less common. The most common two types of IRA are traditional IRA and Roth IRA, both of which are similar but have distinct differences. The less common type of IRAs is SEP IRA and SIMPLE IRA, which we will explain and go deeper into a bit later.
Traditional IRAs
The contributions made into a Traditional IRA are tax-deductible, meaning your taxable income will be reduced by the amount you have contributed to your traditional IRA. For example, you contribute a total of $5,000 into your IRA in 2021 and you had an income of $55,000 in 2021. You will not have to pay taxes on the $55,000, but will only pay taxes on $50,000, with a contribution limit of $6,000 or $7,000 if you are over the age of 50 for 2022. An aspect to consider with traditional IRAs is if an individual is married and they or their spouse has a retirement account at work, the contribution to the IRA is reduced and, in some cases, eliminated.
Another aspect of traditional IRAs is all the earnings in a traditional IRA are not taxed, it is only when a person retires. After which, the individual will only pay taxes on the amount that is withdrawn from the IRA. It is important to note that you will be forced take withdraw funds from the traditional IRA when you become 72 years of age, or 70 ½ if you reach 70 ½ before January 1, 2020. If you start withdrawing money from an IRA account before the age of 59 1/2, then you may be subject to a 10% penalty, with some exceptions. The exceptions are medical expenses, disability, child support, spousal support, military duty, or death.
MAGI: modified adjusted gross income
| Filing status | 2021 MAGI | 2022 MAGI | Deduction limit |
| Single or head of household and covered by retirement plan at work | $66,000 or less | $68,000 or less | Full deduction |
| More than $66,000 but less than $76,000 | More than $68,000 but less than $78,000 | Partial deduction | |
| $76,000 or more | $78,000 or more | No deduction | |
| Married filing jointly and covered by retirement plan at work | $105,000 or less | $109,000 or less | Full deduction |
| More than $105,000 but less than $125,000 | More than $109,000 but less than $129,000 | Partial deduction | |
| $125,000 or more | $129,000 or more | No deduction | |
| Married filing jointly spouse covered by retirement plan at work | $198,000 or less | $204,000 or less | Full deduction |
| More than $198,000 but less than $208,000 | More than $204,000 but less than $214,000 | Partial deduction | |
| $208,000 or more | $214,000 or more | No deduction | |
| Married filing separately you or spouse covered by retirement plan at work | Less than $10,000 | Less than $10,000 | Partial deduction |
| $10,000 or more | $10,000 or more | No deduction |
Above: A table showing how much contributions you can deduct from your income based on filing status.
Roth IRA
Unlike traditional IRAs, the contributions made to a Roth IRA are not tax-deductible. However, the withdraws from the Roth IRA during retirement are tax-free and you will not have to pay taxes on investment gains. Individuals who use Roth IRAs over traditional IRAs will typically have a much longer time until retirement.
For 2021 and 2022, the maximum contribution allowed annually is $6,000 if you are under 50 and $7,000 if you are over. For individuals who are married and filing jointly is $214,000 in 2022. Below is a table will a wider breakdown:
| Filing status | 2022 MAGI | Maximum Annual Contribution |
| Single, head of household or married filing separately (if you didn’t live with spouse during year) | Less than $129,000 | $6,000 ($7,000 if 50 or older) |
| 129,000 up to $144,000 | Contribution is reduced | |
| 144,000 or more | No contribution allowed | |
| Married filing jointly or qualifying widow(er) | Less than $204,000 | $6,000 ($7,000 if 50 or older) |
| $204,000 up to $214,000 | Contribution is reduced | |
| $214,000 or more | No contribution allowed | |
| Married filing separately (if you lived with spouse at any time during year) | Less than $10,000 | Contribution is reduced |
| $10,000 or more | No contribution allowed |
The two less common types of IRA are Single Employee Pension Plans (SEP IRA) and Savings Investment Match Plan for Employees (SIMPLE IRA). Starting with SEP IRAs, there are some requirements for the SEP IRA, which are being a self-employed individual and for those with small businesses, in a partnership, sole proprietor, or self-employment income. The benefit of SEP IRAs is that it allows business owners and self-employed individuals to have access to tax-deferred benefits when planning for retirement, similar to the benefits available while being employed at traditional jobs.
To make a SEP IRA, individuals would only need to open an account with an established financial institution and are funded just like any other investment account. They also have the typical financial security offerings that you can find with any other retirement account. The contributions are also tax-deductible and the investment growth is not taxed until a person retires and starts to withdraw funds from the IRA.
The fourth type of IRA is the SEP IRA. Both SIMPLE IRA and SEP IRAs are considered employer-sponsored retirement plans with advantages when it comes to retirement. SEP IRAs work very similarly to SIMPLE IRAs, with tax-deferred growth on the investment growth and tax-deductible contributions for the business.
Although they may seem quite like each other, they have distinct differences. SEP IRAs do not allow employees to contribute to the plan, only employers. The size of the company also matters, as any size company can use SEP IRA, whereas SIMPLE IRAs are used by companies with less than 100 employees.
The maximum amount an employee can contribute to their SIMPLE IRA is $13,500 in 2021 and $14,000 in 2022. SEP IRAs are different as they do not allow employee contributions, but they do allow employers to contribute up to $58,000 in 2021 and $61,000 in 2022, or 25% of the employee’s total compensation, depending on which is less. The SEP IRA is used by employers as a flexible way to contribute to their employee’s retirement.
If a company experienced an excellent year with a strong cash flow, they can distribute the profits to the company’s employees, up to the maximum allowed contributions. If the company has not had a good year financially, then they are able to reduce the contributions based on the cash flows. The contributions made to the SEP IRA will be tax free, but the income during retirement will be taxed just like any other income.
It is possible to have more than one IRA account and can be beneficial to a person’s financial goals as different IRA have slightly better advantages. Each IRA account will be its own separate account and they cannot be mixed together. The contributions made to the IRAs must stay within the legal requirements. Although it is possible to have more than IRA, many do not, as having several different IRAs can be hard to manage and having a CPA do the work can get costly.
If you own a business with less than 100 employees, then the SIMPLE IRA would be best suited for your company. If you have a company with more than 100 employees, then the SEP IRA would be the best choice to make. An interesting point to note is that the contribution amount would be the same for all eligible employees in a company, no matter what level the individual is.
When it comes to IRAs, there is no best answer as each type of IRA is best suited for a particular situation. Although there are several types of IRA a person can choose from, the most common are the traditional IRA and Roth IRA. Choosing between the two would depend on whether your tax rate will be higher or lower than when you enter retirement and start withdrawing money from the IRA account.
The costs between a traditional IRA and a Roth IRA can be the same in regard to their fees, minimum balances, terms, and conditions. Many brokerages offer relatively similar terms and benefits such as career counseling, limited-time free management, and cash bonuses. Examples of established brokerages to consider are Fidelity, E*TRADE, SoFi Automated Investment, and Ally Invest IRA. Read How to Create a Financial Plan.
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