Part 3: Roth IRA
A Roth IRA is an account that allows you to make after-tax contributions that grow tax-deferred and qualified withdrawals are tax-free. This means you don’t pay any taxes on the interest, dividends, or growth while the money remains inside of the IRA and even when you withdraw funds at retirement.
Similar to a traditional IRA, a Roth IRA is a personal retirement account that offers a large selection of investment options. Both accounts also have the same contribution limits, so in 2020, you can contribute up to $6,000 or $7,000 based on your age.
The major difference between the two accounts is that the contributions into a traditional IRA are tax-deductible, while the contributions into a Roth IRA are not. Also, based on your income, you might not be eligible to contribute to a Roth IRA. It’s important to check with your tax professional to make sure you qualify.
So what is the benefit of a Roth IRA over a traditional IRA account?
The main advantage of a Roth IRA is your account grows tax-free, so the payoff is at the end. Unlike a traditional IRA where your withdrawals during retirement are taxed as income, the withdrawals from a Roth IRA aren’t taxable. Based on your income tax bracket at retirement, this could make a huge difference in your monthly income since you don't have to account for state and federal taxes being withheld or paid when you file your tax return.
Just like we discussed above, compounding interest plays a large role in a Roth IRA as well. Allowing contributions to compound tax-free for 20,30, or even 40 years can make a huge impact on your retirement savings.
Part 4: SEP IRA
If you’re a small business owner, a simplified employee pension individual retirement account (SEP IRA) may be for you. A SEP IRA is a retirement savings account that allows business owners to make contributions that can be tax-deductible and your investments grow tax-deferred. This means you don’t pay any taxes on the interests, dividends, and gains while the money grows in the account.
Similar to a traditional IRA, withdrawals from the SEP IRA are considered taxable income. Additionally, you may face an additional 10% penalty if you withdraw before the age of 59 and a half.
A SEP IRA also has contribution limits. In 2020, the max contribution is the lesser of 25% of your compensation or $57,000 for the year. Again, it’s a good idea to check with your tax professional to see how much you can contribute to this type of retirement plan.
If you have eligible employees, you are required to contribute to their accounts at the same rate you are contributing to your plan. For example, if you’re saving 15% into your SEP IRA, you must also contribute 15% of your employee’s compensation into their SEP IRA.
SEP IRAs offer a lot of flexibility for business owners because they don’t require you to commit to contributing every year like many other retirement plans. SEP IRAs are also easy to set up and maintain and can be combined with traditional and Roth IRAs.
Now that you have a better understanding of how retirement accounts work and which option — or options — is best for you and your financial goals, you’re equipped to start saving. The most important thing is to begin as soon as you possibly can.