An Individual Retirement Account (IRA) investment vehicle is often the first thing people think about when planning for retirement—and for good reason. IRAs offer valuable tax advantages that make them an important step toward a comfortable and secure retirement for many investors. But even though IRAs are a common investment account, it’s important to be aware of how they work, the IRA investment choices you have and the different types of IRAs that exist. Whether or not a IRA is a good option for you depends on the type you choose and your personal financial situation—which will determine your asset allocation.
Regardless of the type, an IRA can hold a wide variety of assets, including:
So, which IRA investments should you have? There is no one “right” answer for everyone, because each type of asset fills a specific need in your retirement plan. Typically the best investments for you largely depend on the right asset allocation for you—this is your mix of stocks, bonds, cash and other securities.
Generally speaking, if you have a long time horizon and need a higher return, your asset allocation should be weighted more heavily in stocks (or stock-focused mutual funds and ETFs). If you have a short time horizon and low return expectations, then you may want to weight more in CDs and fixed income securities. For many investors, their retirement allocation will be a mixture of stocks and bonds, with other asset classes sprinkled in to help achieve the desired goals.
We can help you determine the optimal asset allocation, as well as assist you in picking the right type of IRA.
Contribution Limits: Traditional IRA. If you are a US taxpayer who isn’t an active participant in an employer-sponsored retirement plan, you are likely eligible to contribute to a Traditional IRA—up to $6,000 annually for an individual.* If you are 50 or older, a “catch-up” provision allows you to contribute up to $7,000 per person annually.
Some or all of your Traditional IRA investment growth may be fully tax deductible so long as your employer doesn’t offer a qualified retirement plan. Further, there are no income limits to contributing to a Traditional IRA. Contributions can grow tax deferred until they are withdrawn—ideally in your retirement years when your income and tax rates are lower—but watch out for heavy penalties if you withdraw funds before you are 59 ½.
Roth IRA. A Roth IRA has the same annual contribution limits as a Traditional IRA; the main difference is when you pay taxes. With Roth IRA investments, you don’t get a tax break up front on your contributions, but you also don’t have to pay tax on withdrawals during retirement—the exact opposite of a Traditional IRA.
A Roth IRA also gives you a bit more flexibility than a Traditional IRA. You can withdraw contributions at any time, for any reason, penalty-free—although you will be penalized if you withdraw any Roth IRA investment earnings before age 59 ½. Roth IRAs also allow you to leave your money untouched as long as you like; in contrast, a Traditional IRA requires minimum distributions when you reach age 72. (Note: Roth IRAs are generally subject to RMDs after the account holder dies).
SEP and SIMPLE IRAs. Both SEP (Simplified Employee Pension) and SIMPLE (Savings Incentive Match Plan for Employees) IRAs are designed for self-employed individuals, small business owners and their employees. Both are similar to a Traditional IRA in that they allow for contributions to grow tax-free until withdrawn and funds cannot be distributed until age 59 ½ without incurring a penalty. Where they differ is in contribution limits and who makes the contributions.
With a SIMPLE IRA, the employee makes the majority of contributions, with a small contribution required by the employer. Employees can contribute up to $13,000 annually—with a $3,000 per year catchup if you are 50 or over—and employers can match that up to 3% of the employee contribution. Like in a Traditional IRA, employees can take a tax deduction for their contributions to a SIMPLE IRA plan.
With a SEP IRA, the employer makes all of the contributions, which cannot exceed the lesser of 25% of the employee’s compensation, or $57,000. Employees can take a tax deduction on contributions by their employer, up to a maximum of 25% of their annual compensation.
With Traditional, SEP and SIMPLE IRA investments, you will likely incur a penalty (10% in many cases) —as well as pay taxes—on any distributions taken before age 59 ½. With a Roth IRA, you only pay a penalty on early distributions on earnings, not principal contributions.
Generally speaking, investments in most types of IRAs have required minimum distributions (RMDs) once you turn 72; however, Roth IRAs don’t have this requirement.
Your unique situation determines whether investing in an IRA is the best decision for you.
For example, if you have an employer-sponsored 401(k) plan, especially one in which the company matches contributions, you might want to invest in that plan up to the matched limit. In many cases, maximizing contributions to a 401(k) that is matched by an employer can provide greater benefits, but 401(k)s may have greater limitations on the allowed types of investments. Like IRAs, 401(k) plans also have a contribution limit.
If you are curious for more information on how IRAs operate or want to learn more tips on investing for retirement, you can download one of our informative guides.
*IRS.gov, as of 02/13/2020
The contents of this document should not be construed as tax advice. Please contact your tax professional.