What is an IRA?

The acronym IRA stands for Individual Retirement Account. When an employee puts money away for retirement it is usually set aside in a 401(k), 403(b), or other similar program that provides a way to save money for retirement through an employer plan. When an employee changes jobs, they can no longer contribute to the company account and one option may be to “roll over” the funds into another qualified retirement plan, such as an IRA. Individuals can also open an IRA to set money aside for their retirement needs without an employer plan.

According to the Investment Company Institute’s research[21], there is a total of $24.9 trillion in total U.S. retirement assets as of March 31, 2015. Over the last 15 years IRAs have increased in popularity and now hold the largest percentage of retirement assets in the country – accounting for 30 percent of U.S. retirement wealth. Defined contribution plans, such as 401(k)s, 403(b)s, 457 plans, and Thrift Savings Plans are the second largest category and accounted for 27 percent of the market share.21 In what some have called “The Great Retirement Migration,” investors continue to turn to IRAs to help support their retirement needs. 

The IRA itself is not an investment. Think of it like a house. The IRA is the general account type, or the structure of the home, and you will choose where to invest your funds within the IRA. Similar to the different rooms in your home such as the kitchen, living room, bedroom, and bathroom, each room serves a purpose for you to live comfortably. Retirement investments work the same way – each investment avenue provides a different benefit. Having several different types of investments provides a more diverse portfolio and can potentially provide a more comfortable retirement.

As long as the investments are in the “house” they will receive all the favorable tax treatments that IRAs provide. The funds can be withdrawn from an investment without withdrawing it from the IRA. You can change the rooms in your home without changing the structure of your house. If each room represents a type of investment, you can have many different rooms (investments) within your house. You can change investments (rooms) whenever you’d like, without tax consequences. There may be one room with cash in it, a room with stocks, a room with mutual funds, a room with tax liens, and a room with rental property. You can move the money from room to room (or different investment types) as you see fit, and still gain all the tax benefits, as long as they do not leave the house. When you take the investment out of the house (out of your IRA) it is considered a withdrawal and will receive the tax treatment based on the type of IRA and according to the tax laws of that particular account.

Individual Account Types

Traditional IRA

The Traditional IRA is an account with three key features:

1)    Contributions are tax deductible as long as requirements are met,meaning you could potentially reduce your current tax liability with annual contributions.

2)    The funds in the account will grow tax-deferred, meaning they grow within the account without tax until they are withdrawn or taken as distributions. 

3)    When the money is withdrawn it will be taxed as ordinary income. In other words, it will be taxed at the rate your income is taxed. Although the money is taxed on the way out of the account, often owners are in a lower tax bracket at that point in their life and still benefit from the tax-advantaged compounded growth they had received investing their IRA dollars. 

This retirement account dictates that the funds must remain in the account until the account owner is 59½. If they are withdrawn before that time they will be taxed and may be charged an additional 10 percent penalty for premature withdrawal, unless it is on the IRS list of exceptions. Contributions cannot be made beyond the age of 70½, at which time mandatory withdrawals are required each year. These withdrawals are commonly referred to as Required Minimum Distributions (RMDs). 

You can fund an IRA through three different methods: rollovers, transfers, and annual contributions.

A rollover transfers funds from an employer-sponsored retirement account such as a 401(k), 403(b), 457, TSP, etc. into an IRA. Many workers do this when they change jobs. Rolling over a 401(k) to a self-directed IRA benefits the individual by increasing the available investment options from a dozen mutual funds and company stocks, to an array of both traditional and alternative investments. It also reduces the expenses, as 401(k) fees are generally higher than IRA fees and their accompanying investments.

IRAs and cash within the accounts can also be transferred from one custodian to another. These transfers are generally sent directly from an existing custodian to the new custodian, without the account owner handling the funds.

Assuming a direct trustee-to-trustee transfer or rollover occurs from one like account to another, there is no tax liability for either a transfer or a rollover and they do not impact the individual annual “out-of-pocket”contribution limits in the year the transfer is made.

The last method is through yearly “out-of-pocket” contributions. These contributions can only be made by cash, so you cannot move a $5,000 noncash asset into your IRA, for example. Each year, cash deposits can be made into an account until April 15 of the following year. For example, when you file taxes for 2015, you can make an IRA contribution until April 15 of 2016, for the tax year ending December 31, 2015. As of 2015, the maximum contribution that can be made is 100 percent of earned income or $5,500, whichever is less. Non-working spouses can make contributions under a special provision in the IRS rules. If the account owner is over age 50 an additional $1,000 can be added to the contribution each year. The household income will determine if the contribution amount is tax deductible or not. Contribution limits may change from year to year and are tied to the rate of inflation.

You can set up and make contributions to a Traditional IRA if you meet BOTH of these requirements:

  • You (or, if you file a joint return, your spouse) received taxable compensation* during the year
  • You were not yet age 70½ by the end of the year 

If both you and your spouse have compensation and are under age 70½, each of you can set up an IRA. You cannot both participate in the same IRA.

*Compensation is defined as the wages, salaries, commissions, bonus, alimony and any other amount that you receive for providing personal services. For individuals who are self-employed, sole proprietors and partners in a partnership, “earned income” is another term for compensation. Passive income such as interest, dividends and most rental income are not considered compensation for the purpose of funding an IRA. 

Roth IRA

Senator William V. Roth introduced the Roth IRA to U.S. retirement savers in 1997. The Roth is similar to the Traditional IRA, but with one powerful difference – the investment profits in a Roth IRA are tax-free. The difference between Traditional and Roth accounts is important to understand because most investors must choose between the two when electing to make their individual contributions.

The Roth IRA contributions do not offer a tax deduction in the year the funds are deposited. In exchange, the after-tax dollars grow tax-free and all money taken out of the account is tax-free, assuming account requirements are met. Because contributions are made with money that has already been taxed, the amount you have contributed (excluding earnings) can be withdrawn at any time without early withdrawal penalties after the account has been established for five years. All profits and growth are required to be left in the account until the account owner is 59½ and the account has been established for five years or longer. These requirements help to protect their tax-free growth and encourage retirement saving

You can contribute to your Roth IRA regardless of your age and can also contribute to a Roth IRA for your spouse. Contributions can be made through a 401(k) rollover, a custodian transfer, or annual contributions, much like the Traditional IRA. The annual contribution limits are the same as the Traditional IRA and an account owner can make combined contributions between both a Traditional and a Roth IRA, if desired. The total contributions to both accounts cannot exceed the annual contribution limits provided by the IRS.

You must meet the Modified Adjusted Gross Income (MAGI) limits (found in the link at the end of the chapter) to be eligible to invest and/or contribute to a Roth IRA. This may disqualify high income earners from directly contributing to the Roth IRA. Fortunately rollover contributions do not have the income restrictions that apply to direct (out-of-pocket) contributions, so you may still be able to transfer an existing plan into a Roth IRA. Additionally, if you do not qualify to directly contribute to a Roth IRA, you may still be able to fund a Traditional IRA and execute a Roth conversion so the funds can still be available for tax-free growth by way of your investments. It is important to consult with a tax professional, CPA, or financial advisor when considering these options.

One of the main benefits of a self-directed Roth IRA is that there is no mandatory distribution (RMD) at age 70½ and you can continue to contribute as long as you have earned income, while still maintaining tax-free withdrawals. Additionally, you may be able to pass along your Roth IRA earnings to  beneficiaries tax-free so they can also benefit from the tax-free savings you’ve accumulated.

When you roll over a 401(k) or IRA it will be transferred under the same structure of the existing account. This means if you roll over a Traditional 401(k), it will become a Traditional IRA and the tax treatment will remain the same (tax-deferred). In the same manner, a Roth 401(k) will roll over into a Roth IRA with the same tax-free treatment. As of 2010, you are able to roll over accounts from 401(k)s directly into their Roth counterparts as well as Traditional IRAs to Roth IRAs via a Roth conversion. It is important to seek tax advice for either of these transactions as the amount of the rollover may be taxed in the year of the conversion. Many investors still find this as an attractive option because of the tax-free growth capability.

When deciding between the Traditional or Roth account options you should ask yourself, “Would I rather pay taxes on the seed or would I rather pay taxes down the road when I harvest the crop?” A Traditional IRA allows you to deduct your contribution amounts from your taxable income, thus reducing your tax liability for that year. Since it is a tax-deferred account you are able to reinvest your money and grow it faster than if the investment gains were taxed, but with the understanding that when you remove the money from your account you will have to pay taxes. You are deciding to defer your taxes until the harvest. On the other hand, Roth accounts are taxed on the seed, or when you put money into your account. While you might not see the benefit instantaneously, when you turn that $5,000 into $20,000 the additional $15,000 you just earned will never be taxed. When the harvest comes, what you’ve cultivated is yours and not Uncle Sam’s. It is important to consider your unique situation and retirement goals and to consult with a trusted tax accountant or tax advisor when making these decisions. 

Traditional 401(k) and Roth 401(k) 

The Traditional 401(k) is a savings plan offered to employees that allows them to set aside tax-deferred income for retirement. The 401(k) is attractive to employers and employees because of the high contribution amounts and large tax deductions available. Plus, at a custodian like Equity Trust, investors still have the ability to self-direct 401(k) investments in both traditional and non-traditional assets. The Roth 401(k) possesses the same benefits of the 401(k) but with the ability to designate a portion of funds as Roth contributions.

Roth contributions may be withdrawn tax- and penalty-free as long as the participant is at least 59½ years of age and has held the account for at least five years. Investors don’t have to worry about income limits and they still receive tax treatment similar to a Roth IRA. This plan is available to anyone with a 401(k) and is a benefit to higher-paid employees and self-employed individuals who may have been excluded from having a Roth IRA because of income limitations.

Contributions to a Roth 401(k) are irrevocable, meaning once the money goes into the account participants may not later decide to move the funds into a regular tax-deferred account. The Roth 401(k) has the same distribution requirements as the Traditional 401(k) and participants must begin taking minimum distributions by age 70½, which contrasts with requirements for the Roth IRA. Account holders can often avoid this distribution requirement by rolling over their account into a Roth IRA. 

Small Business Account Types (and Why You May Qualify as a Small Business)

Whether you know it or not, you may be eligible for government-sponsored small business retirement plans such as the SIMPLE IRA, SEP IRA, Solo 401(k) and Roth Solo 401(k). Being an investor often qualifies you as selfemployed, a sole proprietor or even as your own small business.

The advantages of a self-directed SIMPLE, SEP, Solo 401(k) and Roth Solo 401(k) plan over a Traditional or Roth IRA are clear: higher contribution limits and larger tax-deductions. In addition, you are able to contribute to both an individual account such as a Traditional or Roth IRA and a small business plan—truly maximizing the investing power of your self-directed retirement accounts.

It’s important to know the basic facts about each plan before making an investment decision that will impact your future. The following is a brief overview of the SIMPLE, SEP, Solo 401(k) and Roth Solo 401(k):

Simplified Employee Pension (SEP) IRA

This is a retirement account that is available to small business owners who typically employ fewer than 25 employees and allows individuals to make contributions toward their own retirement without getting involved in a more complex qualified plan such as a 401(k). Any employer (whether a corporation, partnership or self-employed individual) may establish the plan, even if there’s only one employee.

The SEP IRA operates much like a Traditional IRA in that the contributions are tax deductible to the business, the earnings grow tax-deferred, money cannot be withdrawn without penalty until the account owner is 59½, and withdrawals are taxed as ordinary income. SEP IRA owners are also required to make RMDs when they turn 70½. Small business owners like these plans because they are simple to set up and are a cost effective way to plan for retirement. 

The advantage of a SEP IRA over a Traditional IRA is that the contributions limits are much higher. An account owner can contribute up to 25 percent of the earned income of each employee, up to $53,000 per year, compared to the $5,500 limit for the IRA (for 2015). This plan is an employer contribution plan and employees cannot contribute directly. The plan must cover all employees who earn at least $550, are at least 21 years of age, and have worked for the employer in three of the last five years. For a full list of exemptions consult with your tax advisor or visit the IRS website.

Savings Incentive Match Plan for Employees (SIMPLE) IRA 

A SIMPLE IRA is another plan option for small business owners and is popular with investors who pay themselves $45,000 or less. It’s an incentivematch plan designed for small businesses with 100 or fewer employees that have no other qualified plan. With a SIMPLE IRA, an employer contributes a percent-based salary match to its employees’ SIMPLE IRAs, while the employees make elective salary deferrals. The basic framework of this account is similar to a Traditional 401(k) or IRA with the same tax deduction, tax deferment and withdrawal rules.

The SIMPLE IRA was designed specifically to help small business owners (you, if you’re self-employed or a sole proprietor) offer a retirement plan to their employees. The main advantage of this plan is that the account balances compound tax-deferred until funds are withdrawn. Plus, an employee can contribute 100 percent of his or her annual compensation, up to a maximum of $12,500 for those under the age of 50 and $15,500 for those employees over the age of 50 (for 2015). Employers are generally required to provide a company match, rather than a set contribution amount to all employees. If the
employee does not make a contribution with his or her own funds, the employer is not required to contribute to that employee’s account. 

You can set up a SIMPLE IRA plan if you meet BOTH of the following requirements:

  • You meet the employee limit.
  • You do not maintain another qualified plan, unless the other plan is for collective bargaining employees.

Solo 401(k) and Roth Solo 401(k) 

The Solo 401(k) is often the most attractive plan to investors, if they qualify, because it combines elements of both the SEP and SIMPLE. This plan is designed for owner-only businesses and spouses. It can be established by both incorporated and unincorporated businesses, sole proprietorships, partnerships and corporations.

You can contribute annually through salary deferral, plus a profit-sharing portion of 0 to 25 percent of your salary. The Solo 401(k) is derived from the 401(k) plan. The only difference is that the Solo 401(k) was designed for owner-only businesses and spouses, while the 401(k) plan is sponsored by companies with multiple employees. The Solo 401(k) plan must be the only plan maintained by the business and the business can’t be considered part of a controlled group under tax law. 

Two components comprise the maximum Solo 401(k) plan contribution:

  • An employee salary-deferral contribution – The employee can contribute up to $18,000 annually ($24,000 if age 50 or older) through salary deferral in 2015, although this may not exceed 100% of the employee’s pay.
  • An employer profit-sharing contribution – The annual limit for this is $35,000 or 25% of the employee’s pay (20% for a self-employed person) for 2015. 

The total annual contribution limit from both sources for those under age 50 in the year 2015 is $53,000. As you can see, for those who meet the eligibility requirements, there is the potential to contribute as both the employer and the employee to maximize
your tax-advantaged retirement savings. 

Would you like the same benefits of the Solo 401(k) but with the tax benefits of Roth-type contributions? Consider the Roth Solo 401(k). In 2006, Congress merged two of the most popular types of retirement savings plans, the Roth IRA and the Solo 401(k) into a Roth Solo 401(k). The Roth Solo 401(k) possesses the same benefits of the Solo 401(k), but with the tax benefits of Roth-type contributions. If you want Roth tax advantages (tax-free distributions) with a substantial contribution limit, then the Roth Solo 401(k) is for you. Also, if you are interested in a Roth IRA, but you don’t qualify because of income limits, then the Roth Solo 401(k) is an option to consider. The same contribution limits apply as the Traditional Solo 401(k) but you can designate the salary deferral contributions you make as Roth contributions. The portion you contribute as Roth does not qualify for a tax deduction but the profits from these contributions grow tax-free, plus all qualified distributions are tax-free. The profit-sharing portion (0-25 percent of your salary) of the Roth Solo 401(k) is just like the Traditional Solo 401(k) and is tax-deferred. 

The advantages of a Traditional or Roth Solo 401(k) plan over a Traditional or Roth IRA are clear: much higher contribution limits and larger taxdeductions. It truly is the most powerful retirement plan you have at your disposal! 

Health Savings Account (HSA)

Affordable health care has become a priority for many Americans because the cost of medical care and insurance continues to skyrocket each year.

Fortunately, an option exists that gives you control over your medical expenses and how to save for those expenses – the self-directed Health Savings Account (HSA). Taking advantage of an HSA requires two parts: a high-deductible health insurance policy to cover large hospital bills and an investment account from which you can withdraw money tax-free for medical
care.

Contributed funds accumulate with tax-free interest allowing you to use those funds to pay for any qualified medical expense you choose.

Imagine lowering your health-care costs today (up to 70 percent less in premiums), while saving for future medical costs by investing in what you know. It’s possible with a self-directed HSA. Plus, you take control of what medical expenses to pay. It’s not decided for you by a complicated health plan. The items below are just some of the benefits a self-directed HSA provides: 

  1. Contributions are tax-deductible (subject to limitations)
  2. Contributions can be invested in the same way as a self-directed IRA, accumulating profits without tax
  3. Distributions are never taxed if used for qualifying medical expenses
  4. Account balances are carried over one tax year to the next; forget about “use-it-or-lose-it” medical savings accounts 

First, you must be enrolled in a High Deductible Health Plan (HDHP). HDHPs are typically defined as a health insurance plan with a minimum deductible of $1,300 for self-only coverage or $2,600 for family coverage. Annual out-of-pocket expenses, including deductibles, can’t exceed $6,450 for self-only coverage or $12,900 for family coverage (for 2015). Next, you contribute pre-tax dollars to an HSA. For 2015, individuals under the age of 55 can contribute $3,350 and families can contribute up to $6,650.

You can invest into almost anything you want with your HSA – from stocks, bonds and mutual funds to real estate and other alternative assets – which makes a self-directed HSA unique compared to other medical savings plans. Invested funds grow tax-free. When it’s time to pay for routine medical expenses such as prescriptions or routine doctor visits, you decide whether to pay for them out of your HSA or pay out-of-pocket and save your HSA for future medical costs. Your HDHP can cover the larger medical expenses. By joining an HDHP, you can immediately cut your health costs by as much as 70 percent. How? Premiums for HDHPs are generally much lower than low-deductible health plans. Unlike certain IRAs, there are no income requirements or restrictions for HSAs.

However, to be eligible for an HSA, you must be covered by an HDHP, must not be covered by other healthinsurance (this does not apply to specific injury and accident insurance, disability, dental care, vision care, or long-term care), must not be enrolled in Medicare, and can’t be claimed as a dependent on someone else’s tax return. HSAs are tax-advantaged as long as they remain Health Savings Accounts. Funds contributed or earned within the account are never taxed if used to pay qualified medical expenses. However, funds not used for qualified medical expenses are subject to a 10-percent penalty and are taxed as ordinary income for individuals under age 65. Individuals over 65 aren’t subject to the 10percent penalty, but the funds are taxed as ordinary income.

Your HSA is entirely portable and follows you if you change jobs. Plus, you determine how much is contributed to it each year and whether to pay current medical expenses from the account or save the money for future expenses. If you’re unemployed or laid off and are collecting unemployment insurance, you may use funds from your HSA to pay for your health insurance premium and routine health expenses – all tax-free. You may also spend tax-free money out of your HSA for long-term care insurance. However, if your new job has a low-deductible health plan, you will no longer be able to contribute but still can invest your current funds.