An individual retirement account (IRA) is a tax-deferred retirement savings plan that allows people to take advantage of compounding interest that grows over time until the person is able to begin making withdrawals upon reaching age 59-1/2. However, the world of IRAs is broad and diverse with numerous subtypes that include small businesses and the self-employed.
How Does an IRA Differ from a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that allows employees to start saving money for retirement by setting aside a certain percentage of the employee’s paycheck toward contributions. Retirement savings from the 401(k) is tax-deferred, meaning the person is taxed only at the time of withdrawal after age 59-1/2.
Like the 401(k), the IRA is also tax-deferred, incurring taxes only when the person goes to withdrawal IRA funds after age 59-1/2. However, many IRAs are not employer-sponsored, thus contributions are made directly by the individual rather than coming from his or her paycheck. Furthermore, non employer-sponsored IRAs do not provide matching.
What are the Types of IRAs?
Many IRAs are individual rather than employer-sponsored. This means that IRA contributions are made separate and apart from regular contributions deducted from an employee’s salary. However, IRAs do exist for small businesses and the self-employed. The types of IRAs vary from the traditional IRA, Roth IRA, SIMPLE IRA, SEP IRA, self-directed IRA, and the Coverdell Education Savings Account.
- Traditional IRA. With a traditional IRA, taxpayers can enjoy a reduction in taxable income since contributions are tax-deductible. However, when the person begins to withdraw IRA funds at retirement (or beginning at age 59-1/2), the funds are taxed as income.
- Roth IRA. The Roth IRA adds a bonus to the IRA landscape: tax-free withdrawals. While the taxpayer isn’t able to enjoy a reduction in taxable income from contributions, the Roth IRA is tax-free upon withdrawal of funds starting at age 59-1/2 or when the person retires. This option is good for those who anticipate being in a higher tax bracket upon retirement.
- SIMPLE IRA. SIMPLE stands for Savings Incentive Match Plan for Employees. The SIMPLE IRA is a simplified matching employee pension plan targeted to self-employed workers and small businesses with no more than 100 employees. The SIMPLE IRA is one of the few IRA types that are employer-sponsored, though it acts more like a 401(k) profit-sharing plan.
- SEP IRA. The Simplified Employee Pension IRA (SEP IRA) is perfect for self-employed individuals and small businesses. The SEP IRA acts quite like a traditional IRA, only it’s highly simplified and easier to administer.
- Self-Directed IRA. Self-directed IRAs allow a person or entity to make investments on behalf of the retirement plan, including directing the way individual funds within the IRA are allocated.
- Coverdell Education Savings Account. Formerly known as the Educational IRA, the Coverdell Education Savings Account (ESA) is a type of IRA that allows people to save for educational expenses from grade school through college. The ESA is unique in that it provides not only tax breaks on contributions, but it also provides tax-free withdrawals.
The Bottom Line on IRAs
Bottom line, the IRA is a very worthwhile retirement savings investment option for individuals and small businesses. For those who already have a 401(k) plan with their employer, an IRA is handy to have for rollovers when the person changes jobs. The SEP IRA and SIMPLE IRA are both handy for self-employed workers and small businesses, and the Coverdell Education Savings Account is a great way to save for college expenses.
See related articles, “ Retire Tax Free With a Roth IRA," "What is a Roth 401(k) Retirement Plan?" and "How to Roll a 401(k) to an IRA."
Daniel Gansle - Daniel J. Gansle is the author of 2012: Day of Reckoning, graduate of Anthropological Studies and expert in ancient Mayan culture.
