Benjamin: Should I Choose a Traditional, Roth, or SEP IRA?

(source: cowbite)

Choosing where to put your personal retirement savings can be a difficult choice. What do Roth and SEP even mean? Hopefully, the summary and comparative visual chart that follows will help to take the stress out of choosing where your retirement funds should be located and reaffirm the decision for those who have already made the choice.

The Traditional IRA

A traditional individual retirement account (IRA), is a retirement investment account that allows you to save up to an IRS set level each year towards your retirement ($5,000 is the maximum in 2009). Any contributions you make to a traditional IRA can be deducted from your taxes, however, you must pay taxes on your distributions when you withdraw money (contrary to a Roth IRA). Distributions can be made without penalty at age 59 and 1/2. Traditional IRA’s differ from Roth IRA’s, which allow you to get distributions tax free in exchange for contributing post-tax funds.

One very nice aspect of traditional IRA’s is that you can contribute for the previous tax year up until the tax filing deadline of the present year (i.e. you can contribute and get a tax deduction for 2008 up until the April, 2009 tax deadline for 2008’s taxes). You cannot do this with a Roth IRA.

The Roth IRA

A Roth IRA is a retirement investment account that allows you to save up to an IRS set level each year towards your retirement. The ‘Roth’ in ‘Roth IRA’ simply comes from its legislative sponsor, William Roth, and has no definitive quality. Any contributions you make to a Roth IRA are after tax, however, you do not have to pay tax on your distributions when you withdraw money in retirement. Distributions can be made without tax and penalty at age 59 and 1/2. Any contributions to a Roth IRA may be withdrawn tax free. It’s money that you’ve already paid taxes on, after all.

Roth IRA’s differ from traditional IRA’s, which allow you to deduct taxes when you contribute funds in exchange for having to pay tax on distributions down the road. It’s also worth noting that you can contribute to both a traditional and Roth within the same calendar year, but the $5,000 max is combined. In other words, you can’t be sneaky and contribute $5,000 in each for a total of $10,000.

The SEP IRA

An SEP (Simplified Employee Pension) IRA is a type of retirement account that an employer or someone who is self-employed can establish. SEP IRA’s have the same contribution limits as Keogh plans and contributions are tax deductible. You may open an SEP IRA if you have self-employment income from freelance or other work. Other than contribution limits, SEP’s pretty much operate in the same way as traditional IRA’s.

The maximum amount that you can contribute to an SEP IRA is capped at 25% of an employee’s compensation. The maximum dollar allocation is $49,000 in 2009, with the maximum considered compensation being $245,000. Because of this, it is a highly desired option for the self-employed who have already maxed out on their traditional and Roth contributions, yet still want additional tax deduction benefits.

A Comparison Between the traditional, Roth, and SEP IRA’s

Conclusion

There’s still time to benefit from contributing to an IRA before the end of tax season. If you contribute within the next 19 days you may qualify for a tax deduction of up to $1500. Mint’s IRA Advisor can walk you through the questions you need to ask yourself in order to know if you qualify and help you determine which IRA is right for you.

For more of GE Miller’s writing, visit 20somethingfinance.