What are the Various Types of IRA?

You have heard of the traditional IRA and the Roth IRA. But from time to time, you may come across other types of IRAs and wonder what they mean.  Here is a brief listing of the major IRA types and their special characteristics. 

Rollover IRA: This is typically a traditional IRA type of account, but the difference is that the source is from another tax-advantaged account type, usually from a 401k/403b rollover distribution. It is simply called the rollover IRA because that’s how brokerage firms (custodians) open up the account when they receive an incoming rollover into a new IRA account. Is there any difference in marking an IRA as a rollover account?  If you do have a rollover IRA, you may want to keep that account separate for a couple of reasons.  Reason one: if you ever intend to roll over that rollover IRA back into a new employer’s workplace retirement plan, sometimes they will only accept rollover IRAs.  Reason two: a workplace retirement account has stronger legal protections under ERISA than an IRA might.  As long as you don’t comingle other funds with the rollover IRA, you will keep those ERISA protections in place. 

Inherited IRA: Also known as the beneficiary IRA. As the name implies, this type of IRA is established when a decedent’s IRA is distributed into an inheritor’s or beneficiary’s account. There are some special rules with this type of account.  No new contributions can be made into these IRAs, and there are some rather strict rules regarding how soon they need to be distributed from the accounts.  Prior to the SECURE Act of 2019, inherited IRAs could be distributed based on the remaining life expectancy table of the beneficiary. But that has been reduced to a limit of 10 years starting with death in 2020 or later. There are very specific rules depending the beneficiary type, so please refer to the specific situation in order to determine the best distribution strategy.  Specifically for spousal beneficiaries, the surviving beneficiary spouse can also treat the IRA as their own and transfer the entire amount of the original IRA into their own rollover IRA as described above.

SEP IRA: This type of IRA is available as a form of a workplace or small business retirement plan and stands for Simplified Employee Pension. With this type of IRA, employers can establish and contribute to an SEP IRA on behalf of the employee.  Employees are not allowed to make their own contributions to this type of an IRA.  Contributions made to the SEP IRA are separate from the amount of IRA contributions an individual can make to their regular contributory traditional or Roth IRA.  If you intend to do Roth conversions or the Backdoor Roth IRA at some point, you will want to be aware of how much you have in the SEP IRA, as balances in the SEP IRA are counted in the pro rata tax calculations.  (Backdoor Roth IRA and Roth conversions deserve their own separate discussion.) Starting with 2023, SECURE Act 2.0 Section 601 permits Roth contributions to SEP IRAs, so while the lion’s share of SEP IRAs are traditional (tax-deferred) in nature, we should begin to see more Roth SEP IRAs in the future.

SIMPLE IRA: The acronym SIMPLE stands for “Savings Incentive Match PLan for Employees.” This is another type of a small business retirement plan and differs from the SEP in that with a SIMPLE IRA, employees are allowed to defer a portion of their wage income to contribute to the SIMPLE plan.  This is not unlike a regular 401(k) plan, in which employees contribute a portion of their wages and also receive some amount of company match.  Similar rules apply to the SIMPLE as to the SEP when performing a Backdoor Roth IRA.  As with the SEP IRA, the SIMPLE IRA also now has a Roth version available starting in 2023.  The big caveat with the SIMPLE IRA is that there is a strict two-year restriction period in which rolling over or distributing a SIMPLE IRA has a 25% tax penalty.  There is also a SIMPLE 401(k) plan option.

Spousal IRA: Whereas the above IRA types are official IRA account types, the spousal IRA is not a separate account type at all. It is simply a regular IRA (or Roth IRA) that a non-working spouse can open up and contribute to.  The idea to promote this name might have arisen from the fact that IRA contributions require earned income, and it’s conceivable that a non-working spouse may belief that they are not entitled to contribute to an IRA because of their lack of working income.  But as long as the spouse is a joint income tax filer (married filing jointly; MFJ status), then the spouse has the ability to open up an IRA in his or her own name based on the spouse’s earned income.  So, if there is one primary earner in the household, both spouses can contribute the annual maximum to an IRA as long as the working spouse’s earned income is greater than the sum of both IRA maximum amounts, assuming all other eligibility requirements are met.

Nondeductible IRA: This too is not a separate type of IRA account type. Instead it is a special term that refers to the tax treatment of a contribution made to a traditional IRA account.  Under “normal” circumstances, contributing to a traditional-type of IRA will result in a reduction of taxable income and allow you to pay less taxes for that contribution. However, depending on the modified adjusted gross income (MAGI) and a few other factors like participation in a workplace retirement plan and tax filing status, some taxpayers may not qualify for tax deductions because their income is over the threshold.  A person whose income is above this threshold can still make an IRA contribution, but it will be not deducted from income, or in other words “nondeductible.”  In theory, the same IRA account can have a mix of deductible and nondeductible contributions.  Nondeductible IRA contributions actually have a role to play in executing the backdoor Roth IRA technique, but that is beyond the scope of this brief description.

Self-Directed IRA: This is a separate type of IRA account, but it is not a commonly used form of an IRA. This is an IRA-type which should have been named a bit differently, because there are terms like “self-directed brokerage” and “self-directed 401(k)” that simply mean that the investor is able to choose from any number of stocks, bonds, mutual funds, ETFs and the like, rather than be limited to investments in “managed” accounts. For example, 401(k) plans normally offer a limited number of mutual fund choices to invest in, but sometimes an employer’s 401(k) plan may allow for participants to direct their own investments via a brokerage-window type of sub-account.  With the self-directed IRA, however, the SEC describes it as an IRA held by a custodian that allows investment in a broader set of assets than most IRA custodians permit. Custodians for self-directed IRAs may allow investors to invest retirement funds in “alternative assets” such as real estate, precious metals and other commodities, crypto assets, private placement securities, promissory notes and tax lien certificates.”  Obviously, these types of investments usually require a higher-level of investor sophistication, not to mention a heightened risk of fraud and a lower level of regulatory oversight.

Wondering what type of IRA is right for your situation? Please reach out and ask for a consultation.