Once upon a time, the average person could depend Social Security and a pension from their employer to see them comfortably through their retirement years. Those years are long gone. With the future of the Social Security system in question, and monthly payments that cannot come close to covering living expenses, today’s workers should not depend on Social Security exclusively to fund their retirement. Add to that the fact that very few employers offer pension plans to their employees these days and it should be no surprise that more and more people are choosing to start an Individual Retirement Account (IRA) to fund their own retirement. Before you start an IRA though, you need to understand the different types of IRA’s so you can decide which one is right for you.
What Is an IRA?
An “Individual Retirement Account” (IRA) is a tax–advantaged retirement account that you own and control. Earnings generated can compound on a tax–deferred basis until withdrawal. Think of an IRA as your own personal pension fund. Some employers offer to match contributions to an IRA; however, IRAs are not the same as an employer sponsored pension plan.
Which Type of IRA Is Right for You?
As the popularity of IRAs has grown, a number of different variations on the original IRA concept have evolved. Once you have made the decision to include and IRA is your retirement plans, you will need to decide which type of IRA works best for you and your situation. Some brief highlights for the most commonly used types of IRAs include:
- Traditional IRA
- Annual tax deductible contributions are based on income level.
- Withdrawals can begin at age 59½ and are mandatory by age 70½.
- Taxes are paid on earnings when withdrawn from the IRA.
- Anyone with earned income under age 70½ can contribute up to the annual maximum limit.
- Funds withdrawn before age 59½ are subject to a 10 percent penalty unless an exception applies.
- Traditional IRAs may be converted to Roth IRAs by paying income taxes (but no tax penalties) on the IRA distribution before rolling over to a Roth IRA, regardless of income limits.
- Roth IRA
- Annual contributions are not tax deductible, but eligibility depends on income level.
- Mandatory distributions at age 70½ are not required.
- All earnings and principal are 100% tax free as long as you follow the IRS rules.
- Traditional, SIMPLE and SEP IRAs may all be converted to Roth IRAs by paying income taxes (but no tax penalties) on the IRA distribution before rolling over to a Roth IRA, regardless of income limits.
- Eligibility is determined based on income
- Principal contributions can be withdrawn any time without penalty as long as the required 5-year holding period is met.
- SEP IRA – Simplified Employee Plan
- Established by an employer
- Allows the employer to make deductible contributions to a Traditional IRA for participating employees
- Employer decides how much to contribute, up to 25 percent of income (dollar limits also apply)
- Contribution percentages must be the same for all employees
- Employer decides whether to contribute each year; however, if the employer makes a contribution, even to his/her own account, contributions must be made to all accounts.
- Good for small family businesses
- SIMPLE IRA – (Savings Incentive Match Plan for Employees)
- Designed for small businesses with 100 employees or less
- Allows employees to make salary-reduced contributions and receive matching contributions from their employer.
- Similar to a SEEP IRA; however, contributions may be made by both the employer and the employee.
- Employer is required to match the employee’s contribution up to three percent.
If you have additional questions or concerns regarding the use of an IRA in your retirement plan, contact the experienced Illinois retirement planning lawyers at Hedecker Law, Ltd. by calling (847) 913-5415 to schedule an appointment.