Different Types of IRAs – Traditional IRA, Roth IRA, Self-Directed IRA

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Individual Retirement Accounts (IRAs) are a tax efficient way for individual taxpayers to save money towards their retirement. They were originally designed so that those people who did not have a workplace retirement scheme, such as small business owners and their employees, could save towards retirement in a similar way to those with a workplace scheme.

The growth of Individual Retirement Accounts

As social security becomes less certain and life expectancy grows longer, people worry about pensions. Employer-provided pension plans are also becoming inadequate. Old style defined benefits systems are a problem for employers who offer them. Underlying investments have done poorly in the last decade creating “pension black holes.” Many investors now avoid companies with substantial pension liabilities, encouraging companies to restrict these schemes.

Where they are offered, employer-based schemes are seen as less suitable for the current work environment with the growth of self-employment and a growing willingness to change employers. Individual retirement accounts are more portable, while still having the tax incentives for workers to save. The worker is seen as owning their IRA more than they are a workplace scheme.

A couple of pension terms should be introduced. A Defined Benefit pension is a pension that pays a guaranteed sum, usually a proportion of the final salary. A Defined Contribution pension is when the pension fund buys an annuity that provides a sum every month. IRAs are all defined contribution. A trustee is an institution that runs and holds the IRA. It is usually a bank or stockbroker.

Workplace Retirement Plans

There are many employer-based pension plans that are similar in operation to Individual Retirement Accounts. The most common of these is what is known as a 401(k). This is an employer-sponsored retirement account, but like an individual retirement account it has some portability, and it allows a certain amount of choice. It is however not an Individual Retirement Account as it allows for employer control and contributions. The SEP IRA and the SIMPLE IRA are both types of accounts that are set up to allow small employers to operate tax efficient pension provision without the complex administration needed by more Traditional employer-based pension schemes.

IRAs can be transferred, or “rolled over” into employer pension plans, just as these plans can be rolled over into IRAs, although in both cases this is dependent on the wording of the retirement plan that is receiving the funds.

Main Types of Individual Retirement Accounts

The two main types of IRA, the Traditional IRA, and the Roth IRA differ on how contributions and payments are taxed. In general, contributions to a Traditional IRA are tax-free, but withdrawals are taxed while a Roth IRA is taxed on its contributions, but pension payments are tax-free.

In both cases, the transactions between deposit and withdrawal are shielded from tax. This includes capital gains, interest, and dividends. This can have the practical effect of considerably expanding the savings over what they would be if they were taxed. This is because of the effect of compounding, where a growing investment or debt can snowball as the interest adds to more interest. The difference between a 3% (post-tax) and 4% (no tax) reinvested income over twenty years is not a 1% difference in investment performance but a 38% difference in investment performance.

Traditional IRA

The Traditional Individual Retirement Account was designed in the 1970s and as its name suggests was the original type of IRA. In these accounts contributions are made out of pre-tax assets; in most cases, this means that they are tax deductible. This means that if a taxpayer were to contribute $2,000 to an ISA and they were in the 25% tax bracket, then there would be a $2,000 reduction in taxable income, and so a $500 reduction in tax. This $500 tax reduction is known as a tax benefit. Investments within the account the income and gain are not taxed, as with all IRAs.

The amount withdrawn is still subject to tax. The pension payments are usually taxed at a lower rate than the contributions would have been as the taxpayer will often find themselves in a lower tax bracket when they collect their pension.

There are two main tax advantages to a Traditional IRA compared to making the investment out of taxed income. Firstly the growth and income from investing are tax-free which means that it will compound. Secondly, the tax bracket that the taxpayer will be in is almost always going to be higher when they can afford to save for a pension compared to when they need to withdraw their pension. It could be said that the Traditional IRA defers tax, but this in itself has great advantages.
With Traditional IRAs there are several requirements to take part in the IRA or to take full advantage of it. For example, involvement in a workplace retirement scheme can drastically or fully cut the entitlement to take part in a Traditional IRA, reflecting the fact that Individual Retirement Accounts were intended to help those who did not have access to workplace schemes. This can be at a high level when a spouse is covered by the workplace scheme, but the taxpayer is not to a very low amount when the spouse is filing their tax return separately.

Traditional IRAs are further limited by the amount of taxable compensation the taxpayer gets. Essentially this is earned income, as taxable income from investments does not count towards this total.

Withdrawals from a Traditional IRA can begin slightly before the retiree becomes 60 or else there is a 10% early distribution penalty. The pension payments must start shortly after the retiree reaches 70 if this is not done half the minimum amount that would have been withdrawn is confiscated for tax.

Roth IRA

The Roth IRA is an Individual Retirement Account that does not allow for tax-free contributions. Instead, the withdrawals from the scheme are not taxed.

Roth IRAs were introduced in 1997, and they are now a prime wealth management vehicle, as they offer a lot of flexibility. Unlike many plans, they can be passed to heirs, including the spouse when the two plans can be added together without any penalty. There is also no minimum age before the pension has to start paying out. The combination of the ability to pass on the Roth IRA to heirs and the lack of an age requirement means that Roth IRAs are often used to reduce estate taxes.

Contributions can be made to a Roth IRA if the owner also participates in a work scheme. Although Traditional IRA holders can also contribute to their retirement accounts, this is unlikely to be tax deductable depending on the income level. The withdrawals of the Roth IRA remain tax-free whether or not they were participating in work schemes when contributing, whatever the income

Most of the sums mentioned for income are not pure income figures. They are in fact figures known as the “Modified Adjusted Gross Income for Roth IRA purposes” (often shortened to MAGI). The Adjusted Gross Income (AGI) is the total income with several tax deductions taken out including health savings accounts deductions, some moving expenses, and student loan interest deductions. When considering the amount that should be considered for a Roth IRA’ (the MAGI) more modifications need to be made, such as disallowing rental losses and including interest earned from US Savings Bonds.

Roth IRAs have an upper limit of $5,000 if the taxpayer is under 50 and $6,000 if the taxpayer is 50 or over. These limits have been increasing over the years as the federal government tries to encourage people to provide for their retirement in an era when stock market returns have been disappointing. In 1998 the limits were $2,000 for both age ranges. The lower limit is the amount of earned income that the taxpayer has had in the year.

There are income limits on Roth IRAs. Currently, the limit is $105,000 up to which a Roth IRA can be paid up in full for the year. For joint filers, the limit is $166,000. After that, there is a $15,000 transition amount which phases out the amount; in this income band, there is always a minimum contribution of $200. For married people filing separately, there is only a small allowance, and anyone earning over $10,000 can’t claim any Roth IRA allowance.

The income limits are only for contributions and not for holding the account. This means that the account is still valid and so sheltered for the tax if the account holder starts to earn more than the maximum.

To be tax-free a contribution must have been in the Roth IRA for five years. There must also be a justification for the withdrawal, usually retirement, but disability can also be a reason. If a person has reached the age of fifty-nine years and six months, then there is a presumption that the person has fulfilled the requirement for retirement.

Up to $10,000 can be withdrawn tax-free from a Roth IRA to help buy a home. The person buying a home cannot have owned a home in the previous two years. It is not just the Roth holder who can buy a home under this allowance but also children, grandchildren, parents, and spouses (although step parents and spouses of children do not get this benefit).

Self-Directed IRA

A self-directed IRA is a type of Roth IRA that unlike standard Roth IRAs have the investments decided by the pension holder, rather than the institutional trustee. This allows for the full range of investments to be chosen, which can be an issue when the pension is run through an institution. Exotic types of investments such as real estate, mortgages, franchise holdings, private equity, and tax liens can be included in Roth IRAs but are rarely allowed for in institutionally held Roth IRAs, but they are allowed in self-directed IRAs. Not all investments are allowed; for example, life insurance and collectibles are excluded.

Assets held by self-directed IRAs can be disqualified if the assets were used for the benefit of the account holder. For example, if an office building is held by an account owned by a small business person, it cannot be used by the business.

Converting a Traditional IRA to a Roth IRA

A Traditional IRA can be converted to a Roth IRA. This allows for more flexibility in the way in which the account is distributed. Until 2010 to convert to a Roth IRA the taxpayer needed to have a Modified Adjusted Gross Income of less than $100,000 in the year they are converting their Traditional IRA to a Roth IRA. They also cannot be married and filing separately. In 2010 these restrictions had been abolished.

If the conversion means that there is a surplus of money from the Traditional IRA left over that cannot be included in the Roth IRA as this does not meet the eligibility then this money can be withdrawn without penalty after five years (the so-called seasoning period).

A Traditional IRA can be converted to a Roth IRA through a rollover or conversion. A rollover is when there is a distribution from the Traditional IRA, and this is contributed to a Roth IRA if it is done within 60 days of the distribution. A transfer is when the account’s assets are transferred from a Traditional account to the Roth account with no cashing out. Written instructions should be kept. This can be done as the same trustee transfer or a trustee to trustee transfer. A conversion will mean that any untaxed amounts in the Traditional IRA will then be taxed.