An Individual Retirement Account (IRA) is a savings account with unique tax advantages designed to help individuals save for the future. 

IRAs, specifically Traditional and Roth accounts, are designed primarily for individuals who do not have access to workplace retirement plans, such as 401(k) plans. However, anyone with earned income can opt to open an IRA, and small business employers can also help their employees set up and fund some types of IRAs.

Individuals and employers must open an IRA with an institution – bank, brokerage, federally insured credit union, savings and loan association, or investment company – that has received Internal Revenue Service (IRS) approval to offer these accounts.

Types Of IRAs

There are multiple types of IRAs available to those with an earned income. However, each has different rules regarding eligibility, tax, and withdrawals.

Traditional IRA

A Traditional IRA allows you to contribute a portion of your income before it has been taxed, giving you some tax benefits upfront. In addition, any investment growth won’t be taxed until you begin withdrawing your funds from the account.

When you withdraw money from your traditional IRA, you will pay income tax on it (based on your income tax rate at the time). In addition to income tax, if you take any funds out of your traditional IRA before you reach the age of 59 and a half, you will pay a 10% early withdrawal fee. However, there are a few exceptions to this rule, such as withdrawals for educational expenses and first-time home purchases.

Traditional IRAs are most common for individuals who don’t have an employer-sponsored 401(k) plan, such as self-employed people. Additionally, they are a good option for those who might not have a significant income at retirement, as they won’t be taxed as much as those with a high retirement income.

Roth IRA

A Roth IRA is similar to a Traditional IRA. However, you contribute to your Roth IRA with income that has already been taxed, meaning your retirement funds grow tax-free and can be withdrawn tax-free after you reach the age of 59 and a half, if the account has been open for at least five years. 

Like a Traditional IRA, you will be subject to a 10% early withdrawal fee, unless you meet the exception criteria, if you withdraw from a Roth IRA before reaching 59 and a half.

Roth IRAs are most common for people who might have a high retirement income, as any withdrawals from a Roth IRA won’t be subject to income tax. This is because the taxes have been paid before contributing.

Simplified Employee Pension (SEP) IRA

A Simplified Employee Pension (SEP) IRA pots are made up of optional employer contributions, which Traditional and Roth IRAs do not allow. However, all contributions are tax-free, which means your retirement income will be subject to tax implications, like with a Traditional IRA. 

If an employer sets up and contributes to a SEP IRA for an eligible employee, they will receive tax deductions on their contributions. In addition, under the Setting Every Community up for Retirement Enhancement (SECURE) Act, small business employers get a tax credit to balance the costs of starting a 401(k) plan with automatic enrollment.

SEP IRAs are designed to help small business owners provide employer-sponsored retirement plans. However, employers can decide how much to contribute each year, sometimes contributing nothing. They are also commonly used by self-employed individuals.

Savings Incentive Match Plan for Employees (SIMPLE) IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA, for small businesses with 100 or fewer employees, is similar to a SEP IRA. However, it requires mandatory employer contributions and optional employee contributions.

Employer contributions are mandatory each year. Employers can choose to contribute 2% of the employee’s income regardless of whether they contribute or match the employee’s contributions to the plan, as long as it does not exceed 3% of their compensation. This is how SIMPLE IRAs differ from SEP IRAs, which do not allow employee contributions. 

Similar to a SEP IRA, under the SECURE Act, the government will provide a maximum tax credit of $500 per year for three years to small employers who open a SIMPLE IRA plan with automatic enrollment.

Those who are self-employed are also eligible to open and contribute to a SIMPLE IRA.

Contribution Limits

The IRS has a maximum contribution limit for IRAs. However, this amount may change slightly from year to year to keep pace with inflation, so be sure to check regularly. 

Here are the contribution limits for the four types of IRAs:

  • Traditional and Roth IRAs: The total contribution limit is $7,000 for people under 50 and $8,000 for those over 50. You can split this limit between both Traditional and Roth IRAs, but you can’t exceed it.
  • SEP IRA: The maximum an employer can contribute is the lesser amount between 25% of the employee’s compensation or $70,000.
  • SIMPLE IRA: The total contribution limit is set at $16,500 for people under 50 and $20,000 for those over 50.