Back to Basics: IRA Nuts & Bolts

There are two main types of IRAs to build a nest egg for retirement: traditional and Roth. Let’s go over those first, then we can go over lesser-known types. 

Simply put, an Individual Retirement Account (IRA) allows an investor to save money for retirement in a tax-advantaged way. Whatever the type of IRA, your investment compounds tax-free. Depending on the type of IRA, there may or may not be taxes to pay when you withdraw your money. 

Traditional IRA 

When you contribute to a traditional IRA, you’re using pre-tax dollars. Therefore, your contributions (investments) can lower your income tax bill. Anybody can contribute to a traditional IRA because there are no limitations based on income. 

You can invest in mutual funds and sometimes, individual stocks and bonds. 

You don’t pay taxes on capital gains, dividends, or interest payments until you start withdrawing from your IRA. Once you reach age 72, you must take a Required Minimum Distribution (RMD) every year. And that money is taxed at whatever your tax rate is at that time. 

From the IRS website: “Due to changes made by the SECURE Act, if your 70th birthday is July 1, 2019 or later, you do not have to take withdrawals until you reach age 72.” 

So to recap, you invest with pre-tax dollars, and get taxed when you withdraw money during retirement. 

Roth IRA

A Roth IRA is sort of a mirror image of the traditional IRA. You don’t get a tax break on your income when you contribute, but you don’t pay taxes when you withdraw money from your account. 

So to recap, you invest with taxed dollars, and do not get taxed when you take money out during retirement. You can invest in mutual funds and sometimes, individual stocks and bonds. 

There are other major differences:

• Unlike a traditional IRA, there are no RMDs.
• There are income restrictions. If you make more than $140,000, you can’t contribute to a Roth IRA in 2021.
• If you are married and file jointly, you can’t contribute to a Roth IRA if your household income is over $208,000 in 2021.

Which IRA is better? 

Recall, the accounts are almost the mirror image of each other, so their benefits are almost opposite.

• A traditional IRA most benefits investors who expect to be in a lower tax bracket when they retire, compared to their working years.
• A Roth IRA most benefits investors in the opposite situation. If you expect that your taxes will be higher when you retire, then a Roth is better.

Since you likely can’t predict where you will end up, in a perfect world, you would have both a traditional and a Roth IRA. That way, you get the benefits of both worlds.

SEP IRA 

SEP stands for Simplified Employee Pension. 

Technically, it’s a type of traditional IRA, but within a practice or company. It can be used by a sole proprietor, or a business owner can set it up for employees. 

They get tax benefits similar to a traditional IRA: earnings grow tax-free, and distributions are taxed after withdrawal during retirement. You can invest in mutual funds, and sometimes individual stocks and bonds. 

The main benefit is that annual contributions are much higher than in a traditional IRA: up to 25% of the employee’s compensation, or $58,000 in 2021, whichever is less. 

Importantly, the employer must contribute equally to all employees’ IRAs, including their own. That amount can vary from one year to the next, depending on how the practice is doing, but it must be equal for all employees. 

This account is ideal for practice owners who want a more affordable retirement plan than a 401(k). 

SIMPLE IRA 

SIMPLE stands for Savings Incentive Match Plan for Employees. 

This is again a simpler and cheaper way to offer a retirement plan to employees, compared to a 401(k). Contributions are much less than a SEP: $19,500 in 2021. You can invest in mutual funds and sometimes, individual stocks and bonds. 

The matching portion by the employer is 2 or 3% of each employee’s compensation. 

A SIMPLE is a solid choice for practices with less than 100 employees. 

Self-directed IRA 

The rules, eligibility and contribution limits of a self-directed IRA (SDIRA) are similar to the others. In fact, you can have a traditional self-directed IRA or a Roth self-directed IRA. 

The main difference is what you can invest in, among others, real estate (in the broadest sense), privately held companies, and hard assets like gold and silver. Notable exceptions are collectibles and life insurance plans. These are disallowed. 

This requires a special type of custodian (company) that specializes in this type of accounts. 

SDIRAs tend to be owned by seasoned investors with experience in non-traditional types of investments. 

This is merely an overview of each type of account. For each, there are rules and regulations and prohibited transactions you must follow to avoid getting taxed and penalized by the IRS. There are other types we haven’t covered here: non-deductible IRA, rollover IRA, spousal IRA, inherited IRA, education or Coverdell IRA and back-door IRA.

Phil Zeltzman, DVM, DACVS
Meredith Jones, DVM
Co-Founders of Veterinary Financial Summit