Blue Haven

What type of IRA should I contribute to?

By January 20, 2025 No Comments

When planning for retirement, Individual Retirement Accounts (IRAs) offer a range of options to help you grow your savings while enjoying tax advantages. Understanding the different types of IRAs and their unique benefits can help you make informed decisions. In this article we’ll provide a breakdown of the various types of IRAs you might consider contributing to.

Traditional IRA is a good place to start

The Traditional IRA is one of the most common retirement accounts. Contributions may be tax-deductible depending on your income and whether you’re covered by a workplace retirement plan. Key features include:

  • Tax Benefits: Contributions are often pre-tax, meaning they reduce your taxable income for the year.
  • Growth: Investments grow tax-deferred, meaning you don’t pay taxes on earnings until you withdraw.
  • Withdrawals: Distributions in retirement are taxed as ordinary income. Withdrawals before age 59½ may incur a 10% penalty, except in certain situations.
  • Income Limits: Deduction limits apply if you or your spouse are covered by a workplace plan.

What about a Roth IRA?

A Roth IRA is a popular choice for those who anticipate being in a higher tax bracket during retirement. Its distinguishing feature is that contributions are made with after-tax dollars, but withdrawals in retirement are tax-free. Here’s what to know:

  • Tax Benefits: Contributions are not tax-deductible, but qualified withdrawals, including earnings, are tax-free.
  • Income Limits: Your ability to contribute phases out at higher income levels.
  • Withdrawals: Contributions (but not earnings) can be withdrawn at any time without penalty.
  • Backdoor Roth Option: If your income exceeds the limits, you might consider a backdoor Roth IRA. This involves contributing to a Traditional IRA and converting it to a Roth IRA. Be aware of potential tax implications during the conversion process.

After-Tax Traditional IRA

If your income restricts you from deducting contributions to a Traditional IRA or contributing to a Roth IRA, an after-tax Traditional IRA might be an option. Contributions are made with after-tax dollars, and:

  • Growth: Earnings grow tax-deferred, just like a regular Traditional IRA.
  • Separation of Funds: To avoid tax complications, keep after-tax contributions and deductible contributions in separate IRA accounts. Commingling these funds can create tracking challenges when calculating taxes on distributions.

Many people who have existing Traditional IRAs may be tempted to make after-tax contributions to these accounts. However, we recommend opening a separate IRA and directing any after-tax contributions to this separate IRA. This will help make sure after-tax contributions do not get commingled with pre-tax contributions.

If you do make after-tax IRA contributions, make sure you file Form 8606 with your tax return.

Spousal IRA for non working spouse

A Spousal IRA allows a non-working or low-earning spouse to contribute to an IRA using the working spouse’s income. This can be set up as either a Traditional or Roth IRA. Key points include:

  • Eligibility: Couples must file a joint tax return.
  • Contribution Limits: The working spouse’s income must equal or exceed the combined IRA contributions for the year.

Small business IRAs

The Simplified Employee Pension (SEP) IRA is designed for self-employed individuals and small business owners. It allows for significant contributions compared to Traditional and Roth IRAs:

  • Tax Benefits: Contributions are tax-deductible.
  • Contribution Limits: Contributions can be up to 25% of compensation or $69,000 (for 2024), whichever is lower.
  • Flexibility: Employers can choose how much to contribute each year.

The SIMPLE IRA, or The Savings Incentive Match Plan for Employees (SIMPLE) IRA is another option for small businesses. It’s easier to administer than a 401(k) plan and offers matching contributions:

  • Tax Benefits: Contributions are tax-deductible.
  • Matching: Employers must match employee contributions up to 3% of their salary or make a 2% non-elective contribution.
  • Contribution Limits: Employees can contribute up to $16,000 annually (for 2024), with an additional $3,500 catch-up contribution for those 50 and older.

Important Notes

  • Income Limits and Workplace Plans: If you’re covered by a workplace retirement plan, your ability to deduct contributions to a Traditional IRA or contribute to a Roth IRA may be restricted based on income.
  • Avoid Commingling Funds: To simplify tax reporting, avoid mixing deductible and after-tax contributions in the same Traditional IRA account.
  • Contribution Limits: For 2023, the annual contribution limit for Traditional and Roth IRAs is $6,500, with a $1,000 catch-up contribution for those 50 and older.

Final Thoughts

IRAs offer a variety of ways to save for retirement, and choosing the right one depends on your financial situation, income level, and long-term goals. Whether you’re maximizing tax-deferred growth, taking advantage of tax-free withdrawals, or helping a spouse build their retirement savings, understanding your options is the first step toward a secure financial future. Always consult a financial advisor or tax professional to ensure your contributions align with your goals and comply with IRS rules.

 

Note: This article was written with the assistance of AI and edited by the author.

Don’t want to miss anything?

Subscribe to our monthly newsletter for market insights.

Leave a Reply