Different Types of IRAs

By LouAnn Schulfer, AWMA®, AIF® Accredited Wealth Management AdvisorSM, Accredited Investment Fiduciary® , Published Author |

Did you know that there are many types of IRAs?  The two main categories are Traditional and Roth. The difference between the two is significant. Contributions or rollover dollars are received into a traditional IRA as pre-tax dollars, growth is tax-deferred with the intent to use the money as retirement income after age 59 1/2, and the money is taxed as ordinary income when distributed from the IRA. A ROTH on the other hand is funded with dollars which you’ve already paid income tax on, also grows tax deferred, and under ordinary circumstances comes out tax free. If you withdraw the growth from your ROTH IRA prior to 59 ½ or five years from your first contribution (the latter of the two applies), or if you take a premature distribution from your traditional IRA, you'd be subject to a 10% IRS penalty and your state tax penalties, in addition to income taxation. My favorite analogy to differentiate the two is to remember tax on the seed vs. tax on the harvest. In a traditional IRA, you do not pay tax on the seed, you do not pay tax on the growth, but tax is due on the harvest. With a ROTH IRA, you pay tax on the seed, no tax is due on the growth, and you can harvest your distributions tax free. Roth distributions are not counted as ordinary income.


Of traditional and Roth, the most distinguishing characteristic is the timing of taxation explained above.  From there, numerous types of IRA’s exist and here is where it gets tricky. To name a few, there are SIMPLE IRAs, SEP IRAs, SARSEP IRAs (which can no longer be established but can be maintained).  SIMPLEs, SEPs and SARSEPs are set up by small business employers who find it more efficient to provide one of these retirement programs versus a 401(k) for their employees.  Education IRAs (which can be really confusing since these are not retirement accounts and finally had their name changed to Coverdell ESA’s), Rollover IRAs, and non-deductible traditional IRAs.   Non-deductible IRAs are a traditional IRA where the owner did not take a tax deduction for the contribution. It may be that the owner earns more than the limit allows to deduct the contribution from their income but still wishes to take advantage of tax-deferred growth as part of their retirement planning strategy.


Beneficiary IRAs are the result of inheriting an IRA from another person. Inheriting as a spouse is optimal because the surviving husband or wife can continue the IRA as if it were their own: Required Minimum Distributions, or RMDs may apply. Inheriting as a non-spouse requires minimum distributions be taken from the IRA if the IRA owner was of RMD age (that is, they were past their Required Beginning Date), even if the beneficiary is not yet of RMD age, and is subject to the “10-year rule,” which says the inherited IRA (or Roth IRA) money must be withdrawn by the end of the 10-year period after the death of the IRA owner. The age of the beneficiary also plays into whether and how much must be withdrawn from the inherited retirement account. The SECURE Act of 2019 created “Eligible Designated Beneficiaries”. EDB’s are people who may receive a higher degree of flexibility in withdrawing funds from their inherited retirement accounts. EDBs include a surviving spouse, the retirement account owner’s child who is under 18 years old, a disabled individual, a chronically ill person, or any other individual who is not more than 10 years younger than the deceased IRA owner.


The IRS penalty for missing an RMD or for not taking a full RMD of any sort, at any age is 25% of the shortfall, which can be reduced to 10% if caught and corrected in time.   


It is important to know that all IRA accounts are subject to their own unique eligibility and contribution requirements. Each is also subject to distribution rules. Further, you may do a rollover of some types of IRAs to combine with another, while in other circumstances, you may not. Why bother? It may be wise to consolidate IRAs as it can save the account owner certain expenses such as annual custodial or other retirement account maintenance fees. However, it is worth your while to know when and in which direction rollovers can occur, as mistakes will be costly. For example, one time in any 12-month period, you may rollover a SIMPLE IRA into an IRA or vice versa, but it must be at least two years after the first contribution to the SIMPLE. You may not rollover a ROTH IRA into a SIMPLE, SEP or Traditional IRA regardless of time periods. I recently had a client who wished to rollover his IRA into his SIMPLE IRA, as the SIMPLE was the larger account. Doing such a transaction would have disqualified the IRA due to the two-year rule, making it a taxable distribution of the entire IRA balance in the year of the rollover. That would have been an expensive mistake!


At one time IRAs may have been simple, but there is a lot to know now. What gets people in trouble most often is that they simply don’t know what they don’t know. This brief summary is general information only and intended to merely point out that there are significant differences between IRA types and their rules for contributions, rollovers, and distribution. This summary is not inclusive of all the rules governing all IRA accounts and by all means, this summary is not intended to provide specific advice or recommendations for any individual. Please consult with your tax advisor for tax advice specific to you or visit the comprehensive site of irs.gov including sections 590 and 970 to learn more. 


LouAnn Schulfer of Schulfer & Associates, LLC Wealth Management can be reached at (715) 343-9600 or louann.schulfer@lpl.comSchulferAndAssociates.com , louannschulfer.com or louann.biz


Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.