Q: I’m ready to start saving for my retirement, but the choices are so confusing! I’m also wondering about the recent changes made to Individual Retirement Account (IRA) products through the SECURE and CARES acts. How do I choose the IRA that's right for me, and what do I need to know?
A: It’s commendable that you’ve started thinking about your retirement planning. There are important distinctions between each type of IRA, so it’s best to review them before making your choice. There have also been several recent changes to the structure and limitations of IRAs with the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019 and the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020.
This comprehensive guide to Individual Retirement Accounts, complete with updated information on the recent changes, can help you choose the option that best suits your needs.
Traditional IRAs are the most straightforward retirement accounts. Contributions are never taxed. Depending on eligibility, they may even be tax-deductible while significantly lowering your taxable income. Investment earnings aren’t taxed and there are no income limits for contributors.
The downside of traditional IRAs comes after contributions are made. All withdrawals made from a traditional IRA during retirement will be taxed at the going tax rate at that time.
Traditional IRAs are great for individuals who are currently in a higher tax bracket and anticipate being in a lower one during retirement. They’re also a good choice for employees who do not have access to a workplace-sponsored retirement plan.
Roth IRAs are similar to their traditional counterparts, but have several notable differences. All contributions and growth are subject to taxes and are not tax-deductible; however, account holders can withdraw their money, tax-free, at retirement, as long as they are age 59 1/2 or older and have had the account for 5 years or longer.
There is also no age limit for contributions, though there are income and contribution limits for eligible contributors. A Roth IRA is a good choice for individuals who anticipate being in a higher tax bracket during retirement and for those who may need to access some of their savings before retiring.
Simplified Employee Pension (SEP) IRAs are designed for individuals who have been employed in their place of work for at least three of the past five years. Contributions are made by the employer and are subject to a maximum amount. Earnings can grow tax-free and the account provides tax benefits for the employer. The annual contribution limits are higher than the limits for traditional IRAs, but are subject to fluctuation along with the business’s cash flow. Also, there are no catch-up contributions allowed for workers who are 50 years old and over.
A SEP IRA can be a good choice for small business owners wanting to avoid the heavy startup and maintenance costs that are commonly associated with conventional retirement plans.
Up until the passing of the SECURE Act, the limit for SEP IRAs was capped at 25% of an employee’s salary or up to $56,000, whichever is less. Now, that limit has been increased to $57,000.
A SIMPLE IRA, or a Savings Incentive Match Plan for Employees, functions similarly to a SEP IRA with the distinction that both employees and employers can make contributions. Eligibility requirements are forgiving, with employees who have earned at least $5,000 from the company opening the plan, and who expect to earn at least that amount in the current calendar year, being eligible to participate.
The contribution limit for SIMPLE IRAs was $13,000, with a catch-up limit of $3,000 until the passing of the SECURE Act, which increased the limit to $13,500. The legislation also established a new tax credit of up to $500 a year for businesses establishing a SIMPLE IRA with automatic enrollment. This credit is on top of the startup credit that is already available. Employers converting an existing plan to one with Eligible Automatic Contribution Arrangements (EACA) are also eligible for the $500 tax credit.
A Spousal IRA can be a traditional or Roth IRA and is designed for married couples where one spouse isn’t eligible for a traditional retirement account. Couples must file a joint tax return to be eligible and the account must be opened in the non-working spouse’s name. Contribution limits are determined by the working spouse’s income.
SECURE Act changes to retirement accounts
The SECURE Act made several significant changes for all IRAs:
RMD changes: IRAs have rules in place for required minimum distributions (RMDs), or a predetermined time when account holders must begin taking distributions. Up until Dec. 20, 2019, all holders of IRAs were no longer allowed to make contributions, and were required to begin taking distributions when they reached age 70 ½, irrespective of their employment status at the time. With the passing of the SECURE Act in December 2019, the age for RMDs increased to 72 years. Also as part of the SECURE Act, IRA holders can now continue making contributions indefinitely, as long as they can demonstrate earned income.
Changes for workplace retirement plans: Previously, employers were allowed to exclude employees who worked fewer than 1,000 hours per year from all retirement plans. With the passing of the SECURE Act, employees who work at least 500 hours in three consecutive years, and are at least age 21 at the end of the three-year period, are eligible to participate in employer retirement plans. This change takes effect in January 2021. Also, small businesses can now team up with other organizations when opening an employer retirement plan, enabling them to provide their employees with access to low-cost plans.
Changes for inherited IRAs: Until the passing of the SECURE Act, non-spousal inheritors of IRAs were allowed to withdraw funds from the account indefinitely. Now, they must empty the account within 10 years.
CARES Act changes to retirement accounts
In March 2020, Congress passed the CARES Act in an effort to mitigate the economic fallout of the coronavirus pandemic. Part of the 300+ page legislation made changes to retirement accounts:
Changes for RMDs: The CARES Act waived all RMD requirements of IRAs for the year 2020.
Special allowances for coronavirus-related withdrawals: The CARES Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans to qualified individuals who have been adversely affected by COVID-19.