1. Create a Traditional IRA
The first IRA, Individual Retirement Account, is now referred to as a "Traditional IRA." Twenty-five percent of the money invested in a traditional IRA is tax deductible for the year the funds are put into the account. For example, if you put $4,000 in this IRA, you can deduct $1,000 from your taxable income. If you are under 49, the maximum contribution to a traditional IRA is $5,000 per year. At age 50, you can put a maximum of $6,000 per year into the traditional IRA.
You work with a custodian, such as a bank or brokerage, to maintain the funds in the account and oversee the investments for the account. When you reach 70 1/2 years of age, you must withdraw the funds from the traditional IRA and pay income taxes on the money. If you have grown money in a traditional IRA for decades, you may find yourself in a high tax bracket in the year you withdraw your funds. If you withdraw funds from the IRA before age 59 1/2, you pay the income taxes plus a 10-percent fee for early withdrawal.
2. Choose a Roth IRA
The Roth IRA, named after William V. Roth, Jr., is one of the most popular ways to create an IRA through a bank or broker. Instead of providing tax benefits while funding an account, a Roth IRA comes with incentives for withdrawing money, because you use "after tax" money to fund the account. Basically, you pay the taxes of a Roth IRA upfront. When you withdraw money from the Roth IRA at age 59 1/2 or older, you don't pay income tax on the funds or any penalties, provided the account is set up with the proper care. You don't have to withdraw funds from a Roth IRA at a specified age.
If you are under the age of 49, you can create a Roth IRA with a maximum of $5,000 going to the account per year, with increases in the limits coming in future years. If you are 50 or older, you can add up to $6,000 to the account each year, with increases of $500 per year coming in the future. In addition, you can convert a traditional IRA into a Roth IRA without penalty, as long as you wait more than 5 years to withdraw funds from the Roth IRA.
3. Create Your Own SEP IRA
The SEP, Simplified Employee Pension, IRA gives small businesses and self-employed individuals an easy way to create an IRA. Barring a few exceptions, you must fill out Form 5305-SEP for each person using the SEP IRA. Each person must be at least 21 years old, must have worked for the same employer for at least 3 of the last 5 years and must have received at least $500 in salary. Unlike the Roth IRA and traditional IRA, you create the SEP IRA in the name of the individual, and employers do not oversee the management of the funds in any way. You allow each individual in the SEP IRA to decide how the funds will be invested.
Contributions to the SEP IRA, which operates like a traditional IRA, are limited on a percentage basis. If you are self-employed, you can contribute just under 18.6 percent of net profit to the SEP IRA. Employers can put up to 25 percent of employees' wages in an SEP IRA.
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