Financially Speaking: Different Types of IRAs
By LouAnn Schulfer, AWMA, AIF, Accredited Wealth Management AdvisorSM Accredited Investment Fiduciary
There are many types of IRAs. The two main categories which you may already be aware of are Traditional and Roth. The difference between the two is significant. Contributions or rollover dollars are received into a traditional IRA as pre-tax dollars, growth is tax-deferred with the intent to use the money as retirement income after age 59 1/2, and the money is taxed as ordinary income when distributed from the IRA. A ROTH on the other hand is funded with dollars which you’ve already paid income tax on, also grows tax deferred, and under ordinary circumstances comes out tax free. You may likely pay a 10% IRS penalty (in addition to income taxation) if you withdraw the growth from your ROTH IRA prior to 59 ½ or five years from your first contribution (the latter of the two applies), or on a premature distribution from your traditional IRA. My favorite analogy to differentiate the two is to remember tax on the seed vs. tax on the harvest. In a traditional IRA, you do not pay tax on the seed, you do not pay tax on the growth, but tax is due on the harvest. With a ROTH IRA, you pay tax on the seed, no tax is due on the growth, and you are able to harvest your distributions tax free.
Traditional and ROTH are the two main categories of IRAs, and their most distinguishing characteristic is the timing of taxation. From there, numerous types of IRA’s exist and here is where it gets tricky. To name a few, there are SIMPLE IRAs, SEP IRAs, SARSEP IRAs (which can no longer be established but can be maintained) Beneficiary IRAs, Education IRAs (which can be really confusing since these are not retirement accounts and finally had their name changed to Coverdell ESA’s), Rollover IRAs, and non-deductible traditional IRAs. SIMPLEs, SEPs and SARSEPs are set up by small business employers who find it more efficient to provide one of these retirement programs versus a 401(k) for their employees. Beneficiary IRA’s are the result of inheriting an IRA from another person. Inheriting as a spouse is optimal, as the surviving husband or wife has the ability to continue the IRA as if it were their own. Inheriting as a non-spouse requires minimum distributions be taken from the IRA on either a set schedule based upon life expectancy or the IRA must be spent down within 5 years. If you miss either of these as a non-spouse, you will be subject to the 50% penalty for missed RMD’s. That is not a typo. The IRS penalty for missing a required minimum distribution at any age is FIFTY percent of what the distribution should have been. Education IRAs now known as Coverdell Education Savings Accounts were established for educational purposes. Non-deductible IRAs are a traditional IRA where the owner did not take a tax deduction for the contribution. It may be that the owner earns more than the limit allows for to deduct the contribution from their income but still wishes to take advantage of tax-deferred growth as part of their retirement planning strategy.
It is important to know that all IRA accounts are subject to their own unique eligibility and contribution requirements. Each is also subject to distribution rules. Further, you may do a rollover of some types of IRAs to combine with another, while in other circumstances, you may not. Why bother? It may be wise to consolidate IRAs as it can save the account owner certain expenses such as annual custodial or other retirement account maintenance fees. However, it is worth your while to know when and in which direction rollovers can occur, as mistakes will be costly. For example, one time in any 12 month period, you may rollover a SIMPLE IRA into an IRA or vice versa, but is must be at least two years after the first contribution to the SIMPLE. You may not rollover a ROTH IRA into a SIMPLE, SEP or Traditional IRA regardless of time periods. I recently had a client who wished to rollover their IRA into their SIMPLE IRA, as the SIMPLE was the larger account. Doing such a transaction would have disqualified the IRA due to the two year rule, making it a taxable distribution of the entire IRA balance in the year of the rollover. That would have been an expensive mistake!
At one time IRAs may have been simple, but there is a lot to know now. What gets people in trouble most often is that they simply don’t know what they don’t know. This brief article is general information only and intended to merely point out that there are significant differences between IRA types and their rules for contributions, rollovers, and distribution. This article is not inclusive of all of the rules governing all IRA accounts and this article is not intended to provide specific advice or recommendations for any individual. Please consult with your tax advisor for tax advice specific to you or visit the comprehensive site of irs.gov including sections 590 and 970.
(Author’s note: Due to industry regulations, I am prohibited from responding to any online comments. I welcome you to contact me via e-mail: [email protected]).
LouAnn Schulfer is co-owner of Schulfer & Associates, LLC Financial Professionals and can be reached at (715) 343-9600 or [email protected]. www.SchulferAndAssociates.com. Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.