When you say IRA, you could mean a lot of things. There are a bunch of IRA types out there, such as SEP IRAs, Simple IRAs, traditional IRAs, Roth IRAs, and more. These are the most common types of IRAs we tend to see with our clients at REAP Financial. More than likely, you have one yourself. Each of these different types of IRAs come with different contribution limits and rules around how you can take your money out. Today, we’ll go over different types of IRAs, so you can identify what the most optimal account is for you, based on your situation.
Simple IRA
We’ll start off with the Simple IRA. Generally, you’ll see these offered with small employers. The contribution limits on these are $16,000 per year as of 2024. Because of this, simple IRAs can be somewhat limited compared to a traditional 401k due to the low contribution limits. However, simple IRAs are pretty straight-forward. Your employer can contribute to these accounts, as they might to a 401k. These days, you’ll find more employers opt for the 401k option, but if you have a simple IRA we recommend you always contribute the max and remember your contribution limits.
Traditional IRAs
This is the most common account we tend to see with successful families at REAP Financial, who have been building for retirement for years. Contribution limits on these accounts are lower, at $7,000 a year as of 2024. If you’re over 50 years old, you can add an additional $1,000 per year as a catch-up contribution, for a total contribution limit of $8,000 per year.
Roth IRAs
Roth IRAs are one of our preferred accounts at REAP Financial. As of 2024, you can contribute a max of $7,000 per year to a Roth IRA, or $8,000 per year if you are over the age of 50. Often, we get the question if you can contribute to both a traditional and Roth IRA. Yes, you can do both as long as you don’t exceed the total contribution amount of $7,000 if you’re under 50. When you are contributing to these accounts, ensure that you’re not going over that limit when you aggregate the contributions.
Roth IRAs vs. Traditional IRAs
But why would you do a traditional account over a Roth? Generally, we want to get tax deductions today. However, as of today, taxes are historically quite low. This means, chasing tax deductions today most likely means you’ll be facing higher taxes down the road. Traditional IRAs give you a tax deduction upfront, taking an amount off of your bottom line. With Roth IRAs, you don’t get the tax deduction upfront; this is one of the reasons we often see Roth IRAs being one of the smaller accounts clients have.
However, the long-term benefits of Roth IRAs are great versus traditional IRAs. Roth IRAs provide tax-free growth forever. That allows you total control of the money in your retirement, without being subject to required minimum distributions. It also grows tax free through retirement and passes tax-free to your heirs. With a traditional IRA, you get that tax deduction at the moment of contribution. However, whenever you pull money out of a traditional IRA, it will be taxed 100% at whatever tax rate is applicable at the time. For this reason, if you want control of your taxes in retirement and you believe taxes will go up in the future, the Roth IRA can create a lasting impact.
For example, let’s imagine you’re pulling money out of an IRA in the future. If you have $10,000 a month you want to withdraw, you’d have to pull around $12,000 out of a traditional IRA each year to net that $10,000 for your budget, when you take taxes into account. With a Roth IRA, if you want to net $10,000, you only have to withdraw $10,000 since the money is tax-free. As you can see, drawing money out of a traditional IRA can have a major compounding effect over time. Since you have to withdraw much more to net the same amount in your budget, you have less money each month in your account working for you. On the other hand, with a Roth IRA, you can withdraw less each month to net the same benefit, meaning more of your money stays in your account, working for you.
For this reason, when we do simple analysis for families headed to retirement or young professionals deciding between IRA accounts, simple math shows that you could have hundreds of thousands or more in your retirement account in your later years simply because more of the money stays in the account over time. It can be really incredible. If you want to do the math yourself, make sure you consider the value of the small tax deduction today versus all the value you’ll accumulate over the years. It’s a very important decision, especially for those who are younger and have a lot of time for the accounts to grow.
SEP IRA
Then, we get to the SEP IRA. The SEP IRA is primarily for self-employed individuals. There are some rules associated with these accounts, especially if you do have employees. For example, there is an obligation to fund these accounts after a certain period, known as the testing period. The SEP IRA is an excellent account, since it has an extremely high contribution rate. As of 2024, you can contribute up to $24,000 per year or up to 25% of your earnings. Remember, you have to be self-employed to access a SEP IRA, so if you’re a W-2 employee you can’t participate in a SEP IRA.
But, what if you do extra work, in addition to a W-2 job? Perhaps you own a business, do consulting, a side hustle, or 1099 work. That may actually qualify you for the SEP IRA, despite your W-2 employment. For this reason, we often are asked whether clients can do a SEP and a traditional IRA. The answer is yes. As long as you have earned income, you can contribute to a traditional IRA. As long as you have self-employment income, you can contribute to a SEP IRA.
We can even take that a step forward. What if you’re a W-2 employee, can you do a 401k, IRA, and a SEP IRA? The answer is again, yes. Even if you don’t have enough discretionary income to max all of these accounts out, you still have a lot of flexibility.
Inherited IRAs
Finally, we get to the inherited IRAs. This is what you may receive from a parent or family member. Over the last few years, the rules around these accounts have changed significantly with the Secure Act 2.0. Under today’s law, when you inherit this money, you cannot put new money into the account; it is a Beneficiary IRA. The money can stay invested upon being inherited and you don’t necessarily have to sell the holdings, depending on how the trustee or executor distributes it to you.
However, when you go to take money out of the account, it will be taxed 100% as income assuming it is a traditional IRA. Additionally, under the Secure Act 2.0, you will have to take the money out within 10 years. You do not have to take any money out in distributions for 10 years, but the entire amount must be withdrawn at the 10 year mark. One strategy could be to leave the money in there and compound over 10 years. However, if you decide to do this, remember that once 10 years have passed and you withdraw the money, it will be taxed as income. If it is a large amount, $100,000 or more, it could create a substantial tax burden when you take it out.
You may also inherit a Roth IRA. If you are the beneficiary of a Roth IRA, those dollars must be distributed within 10 years of inheritance as well. However, when you do distribute those dollars they are tax-free. For this reason, letting an inherited Roth IRA compound and grow for the 10 year period makes a lot of sense, since you won’t face a tax burden at the time of dispersal. Next, we’ll take a moment to go over the downsides of IRA accounts.
Downsides of IRAs & Common Questions
The number one downside of IRAs is that you don’t have liquidity. In most cases, you’re going to lock this money up until you reach your retirement age. If you’re early in your career, that means you’re setting this money aside for the long-game. It is not money you’ll want to pull from in the event of an emergency. If you do have a reach for IRA money in an emergency, you’ll face some drawbacks. If you withdraw money from a traditional IRA before age 59 ½, the money comes out and is taxable in the year you take it out. The money you withdraw also carries a 10% penalty, which goes to the government on top of your tax bill. Those penalties hold true until you reach 59 ½ and apply to SEP IRAs, Simple IRAs, and traditional IRAs.
It’s a bit different for the Roth IRA. The cool thing about a Roth IRA is that it can provide liquidity in the event of an emergency. However, you will be limited in the amount you can access. For example, let’s say you’re putting $5,000 each year into your Roth IRA for four years. Now, it has grown to $25,000. $20,000 of that amount is direct contributions, with $5,000 worth of growth. Over the years, you can take money out of your Roth IRA without a tax or penalty as long as it’s coming from your “basis” or the amount you’ve put in. That means, you can access the amount you’ve contributed to the account over the years (in this case, $20,000), but not the earnings or growth (in this case, the additional $5,000) until age 59 ½.
Now, remember that Roth IRAs grow tax-free forever and come out tax-free after the age of 59 ½. If you have to take out all the money in your Roth IRA before that date, any dollar that is considered growth about your basis will be taxed as income and penalized. Since you’ve already paid tax on that money going into the account, it can feel like a double-tax if you’re pulling it out early. As you can see, while Roth IRAs can build in some liquidity, you’ll really want to be careful to diversify. At REAP Financial, we always stress the importance of building assets in different places and with different tax rules, so you maintain flexibility. The Roth also has a five-year rule. To be able to access money in your Roth, you need to have held that money for at least 5 years. When you convert money from IRAs to a Roth, that conversion must season for 5 years before those dollars can be utilized. As there are additional benefits that come with a Roth, there are some additional rules, which are different from other types of IRAs.
What if you need liquidity?
On these pre-tax accounts we’re discussing, many people have the misconception that they will not be taxed after age 59 ½, since there are no penalties after that age. To be clear, while there are no penalties after 59 ½, you will still face taxes on all accounts except for the Roth IRA. For this reason, you need to make sure you’re spreading your assets out and have a savings strategy that aligns with your desired retirement date.
Can you borrow from your IRA?
In most cases, you cannot borrow from your IRA. However, you can do what is called a 60 day rollover. For example, let’s say you have a taxable IRA, you take out $100,000 to purchase a home, but you can recover $100,000 within 60 days to return to your IRA account. As long as you return the exact amount you borrowed from your IRA within 60 days, you will not face any taxes or penalties. However, if you miss that deadline by even a day, 100% of the amount is taxable. If you don’t return the exact amount to your IRA, every dollar will be taxed and penalized. That is the 60 day rollover, and it can only be done once per calendar year. When it comes to loans, that’s typically something you’re going to find with your traditional 401ks and Roth 401ks. In many cases, you can borrow from your employer plan. All of these things work slightly differently, so it’s important to get all the correct information. If you’re looking for more tips and strategies, make sure you visit reapfinancial.com for additional articles and resources!
Your Retirement, Your Strategy
As you can see, there are many rules and nuances between different IRA accounts. For this reason, it is important to consult with a fiduciary advisor when making these decisions to make sure you set yourself up well for the future. To learn more about fiduciary advisors, check out our YouTube video, “Avoid IRS Control: Ways to Master Your IRA Strategy” and visit our website for more tips and strategies!
REAP Financial, Your Austin Retirement Planners
At REAP Financial, we’re committed to helping you prepare for retirement by exploring all available options and account types. Concentrating all your funds in a single account can lead to significant tax burdens and reduce the overall value of your retirement savings. Diversifying your accounts and implementing smart strategies can help you maximize your retirement benefits.
If you’re in the Austin, Texas area and seeking a skilled retirement planner, connect with our expert team at REAP Financial. We specialize in creating personalized retirement strategies tailored to your unique financial goals and lifestyle aspirations. Let us help you sort through the intricacies of retirement planning, ensuring a secure and fulfilling future for you and your loved ones. Contact us today for a consultation and start your journey toward a comfortable retirement in Austin.
Phone: (512) 249-7300
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REAP Financial
9414 Anderson Mill Rd #100
Austin, TX 78729
