People starting to save for retirement will quickly find that many sources recommend using individual retirement accounts (IRAs) for this purpose. However, they will see that there is a bewildering array of accounts with this name. What is the difference between IRA accounts? Here is a quick overview to help clear things up:
While most IRAs are tax-free until their money is withdrawn, the Roth IRAs do things the other way around. Taxes are paid on money when it is earned, not upon withdrawal. Like anything else, this has its own set of pros and cons. The drawback appears as less money to invest initially since taxes have already been removed. However, the benefit is that when withdrawal time comes, the investor does not have to worry about the disbursal getting minimized. This works out well when a large amount of interest has been earned. Another consideration is that people are only eligible to use a Roth IRA if they are within a certain income bracket. Those who make too much have to choose a different type of account. How much is too much? The answer to that fluctuates with the market and politics. In 2021, the limit for a single head of household is $140,000.
The Simplified Employee Pension (SEP) IRA plan allows employers to add contributions to employees’ traditional IRA plans. Because of this connection, workers must set up a traditional plan before the SEP can start. Once it does, the traditional plan is normally referred to as a SEP IRA. This type of plan is not restricted to traditional employees. It can be set up by the owners of sole proprietorships and other entrepreneurial ventures – even if the owner is the only “employee.” Because of this, there is little difference between personal and small business IRA accounts. One of the main benefits of this plan is that it allows for additional contributions to the regular IRA without running afoul of the original plan’s contribution limits. However, the ability to deduct traditional contributions may be affected.
Traditional IRA Plans
In order to understand the difference between Roth and traditional IRAs, one must know how a traditional IRA works. They are tax-deferred retirement savings accounts that allow for savings over a long span of time. They come in two forms: deductible and non-deductible. The deductible form allows people to deduct contributions from their taxes. This essentially makes the eligible contributions tax-free. Non-deductible plans, as their category name implies, have no such perk. The chosen plan depends mainly on eligibility status, like filing status, income level, the presence or absence of Social Security income.