Tax-Deferred Accounts Part 2: Traditional IRAs & Rollover IRAs

Taxes are a major consideration when you are thinking of setting up an IRA account. Do you want help determining which retirement savings plan offers the best savings and benefits?  Our guide is designed to help you understand two of the most common types of IRA: Traditional and Rollover, and the advantages you can derive from both.

What is an IRA?

An Individual Retirement Account is one of the many methods to safeguard money for your retirement. These do resemble the 401(k) account you will have heard a lot about. However, a 401(k) is a facility that can only be availed through an employer. If you are working and your employer does not offer this service, or you want slightly more flexibility regarding investments, you could think about getting an IRA instead.

These IRAs can be opened through brokerages, investment companies, or banks. You should be aware that only organizations registered with the IRS can allow the facility of opening an IRA, so if you are opting for a bank or personal broker, double-check their status with the IRS.

Traditional IRAs

The main way a traditional IRA works is by allowing individuals to contribute to their retirement savings from their earned income. The money that is contributed to a traditional IRA is not considered a part of your annual taxable income for that year, giving you an immediate tax break. However, the taxes kick in once you make withdrawals on retiring.

How do you open a traditional IRA?

Unlike 401(k)s, IRAs are not opened through your employer. These are “individual” accounts, and therefore you need to get them opened through a broker or financial advisor.

Benefits of a Traditional IRA

If you weigh the pros and cons of a traditional IRA side by side, the pros far outweigh the benefits. A traditional IRA offers you a major tax break in the present when you contribute money to it, and the money is tax-deductible.

Moreover, there is no minimum threshold you must satisfy before you can open such an IRA. There are also certain “qualified” withdrawals, such as those for buying a house or college tuition that can be made before the age of 59.5 years which are not subject to any penalties.

Rollover IRA

A Rollover IRA enables people to move their assets from their 401(k) account to an independent retirement account. While a 401(k) is managed by your employer, an IRA is managed by other experts, such as special brokerages.

The main purpose of using a Rollover IRA is to allow you to move your savings from your employer’s plan to an independent account without having to pay tax. This is important since a Rollover IRA ensures that the money you withdraw from your 401(k) is still tax-deferred, and it does not count as part of your taxable income for the year.

How do you set up a rollover IRA?

There are two main types of Rollover IRAs. The first option is to opt for a direct rollover. This option is relatively hassle-free and easy since the previous 401(k) plan manager can make an account-to-account transfer of your savings. This usually happens through a check or an online funds transfer.

The other option you could opt for is known as an indirect rollover. In this option, you can withdraw the assets from your 401(k) account and keep them with you for almost 60 days. However, you must transfer these savings into a valid IRA account within this period; otherwise, you risk facing tax penalties.  Of important note, this 60 day period is literally 60 calendar days, weekends and holidays included.  Since many rollovers cannot be completed during non-business days, you should allow some buffer room – say 10 days or so before the 60-day period expires – to ensure your rollover is completed.

If you don’t complete this withdrawal to another retirement plan, it will count as a regular withdrawal, and before the age of 59.5 years, you will have to pay 10% tax to the IRS for this.

One important thing to know about a rollover IRA is that the IRS will withhold 20% of your withdrawal and keep it with them until you have filed your annual tax report for that year.

Benefits of a Rollover IRA

There are two key benefits of having a Rollover IRA. The first is that if you have had a longstanding 401(k) account with your employer and are leaving your place of work, the Rollover IRA will allow you to transfer as many savings as you have had in your earlier account without attracting penalties or taxes of any sort.

Secondly, Rollover IRAs have the dual advantage of offering a wider range of investment options for you to choose from without attracting high administrative costs. This means that you have greater freedom to earn money on your savings without you having to pay a fortune in administrative fees.

Rules regarding both Traditional and Rollover IRAs

Different rules govern Rollover IRAs and traditional IRAs. However, with rollover IRAs, one rule is more important than any other: the 60-day time limit. A rollover IRA will allow you to transfer money from a 401(k) to an IRA.

For both types of IRAs, the withdrawal rules will depend on which account types you choose. However, irrespective of whether you ultimately choose the Roth or traditional IRA, one thing you need to observe is that during an indirect rollover, you need to transfer the money you took from your 401(k) to the IRA before 60 days. If you do not, this will be deemed an “early withdrawal,” and the IRS will charge you a 10% tax penalty on it!

Should you get an IRA?

The question of getting an IRA is one of personal preference. The first situation in which you have to get an IRA is if you are leaving your job. If you are not employed, or your employer does not offer a 401(k), the IRA is your only option for retirement savings. The question in such a scenario is not one of “should” but “how” and “when” you should get an IRA.

The second situation in which you may prefer an IRA is to maximize the earnings from your savings through various investment options that your 401(k) provider does not offer. The freedom the IRA offers is significantly greater.

A third situation is perhaps the best – you can have both a 401(k) and an IRA!  Of particular note, you can contribute to a 401(k) (maximum $19,500 in Tax Year 2021 for individuals younger than 50 years of age) and to a Traditional IRA (maximum $6,000 in Tax Year 2021 for individuals younger than 50 years of age), for a total tax-deductible amount of $25,500.  For someone in a 40% tax bracket, this is an immediate tax savings of over $10,000.

What happens to your IRA if you die?

Everyone thinks about this when they make an IRA: what happens to your retirement savings if you die? You do not want the money to fall into the wrong hands and would want it to benefit someone close to you. Your IRA account will ask you to name a particular beneficiary to whom the money should go in case you die. If you are married, your spouse is automatically your beneficiary. However, you do have the option of naming another person as your beneficiary even if you have married, provided that you fulfill the necessary formalities required for it.

Other types of IRAs

While the Traditional and Rollover IRAs are the most common type, there are other options available in the market that you should be aware of.

The most common type of IRA after the traditional and rollover versions is the Roth IRA. The main difference between this and the other two types is that it is not tax-deductible if you contribute to the Roth IRA. If you earn $60,000 and contribute $6000 to your Roth IRA, you will still have to pay income tax on the entire $60,000. The Roth IRA offers no immediate respite from tax. However, when you withdraw from a Roth IRA, no tax is charged, meaning that the tax break comes later on.  We will explore Roth IRAs more in depth in a future article.

The SEP-IRA is an option that is available for people who work in self-employed capacities. In today’s day and age, with the “gig economy” being on the rise, these accounts offer a good retirement saving for people like contractors and freelancers who do not work with anyone. The SEP-IRA can also be set up by entrepreneurs who own small businesses for their employees.

The SIMPLE IRA is also made for such individuals and for people who run small businesses. However, the main difference between the SEP and SIMPLE IRA is that only an employer can contribute to the SEP. In contrast, both an employer and employee can contribute to the SIMPLE IRA.

What kinds of investments can I make?

When it comes to IRAs, whether they be of the traditional or rollover type, the greatest advantage you have is flexibility in terms of investments. With a 401(k) plan, you will be given a choice of investments that your employer’s 401(k) plan administrator offers. These usually contain a wide range of investment options, but the choice is limited since this is an employer-sponsored plan.

You have greater freedom to choose investment options in an IRA. From mutual funds to stocks, the choice is yours. If you want to take on more work, you could also have a self-directed account, where you make all the decisions yourself. This kind of account gives you the most choice in terms of investment options, barring only those investments that the IRS has expressly forbidden for retirement savings.

What are the drawbacks of an IRA?

While IRAs are generally beneficial, there are certain drawbacks that you should be aware of. Firstly, with traditional IRAs, the tax break you get today is not permanent. You will need to pay taxes once you start withdrawing money, and if you have progressed to a higher tax bracket, the taxes you pay at retirement can be much more than what you would have to pay today.

Secondly, with rollover IRAs, you have to be very careful regarding time limits and rules. While rolling over your income from a 401(k) to an IRA sounds easy, there can be a lot of paperwork and red tape involved, particularly if you opt for the indirect rollover.

Lastly, IRAs have significantly lower contribution limits than 401(k) accounts do, thus making it more difficult for you to save a lot.

Are you still confused about which IRA option is better for you? Please contact us regarding IRAs and other retirement savings plans you qualify for. Our team will be happy to discuss your individual situations to ensure you have the right accounts open and are contributing to them optimally.

October 11, 2021
RVW Wealth