Congress created individual retirement arrangements (IRAs) to help employees prepare for their retirements. Several types of IRAs exist, including traditional, Roth, savings incentive match plan for employees (SIMPLE) and simplified employee pension (SEP). All IRAs can accept tax-free rollovers from eligible accounts, but the term “rollover IRA” refers specifically to a traditional IRA that receives special handling.
SIMPLE IRA vs Traditional IRA
An individual can choose to open a traditional IRA and deposit before-tax earnings into it to gain certain tax benefits. Traditional-IRA contributions are deducted from your annual income, and the money in the account can grow tax-deferred until you withdraw it at a later date. Withdrawals are treated as ordinary income and taxed at your marginal tax bracket. You will be assessed a 10-percent penalty tax for early withdrawals (that is, before age 59 ½) unless the withdrawal qualifies for a penalty exception. You must begin taking required minimum distributions from your traditional IRA starting at age 70 ½.
A SIMPLE IRA is an employee retirement plan established by your employer. SIMPLE IRA tax advantages are similar to those available through a traditional IRA, with some important differences. To begin with, an employer can set up a SIMPLE IRA only if it has 100 or fewer employees who receive at least $5,000 per year in compensation. A self-employed individual can also set up a SIMPLE IRA. Employees eligible to participate in a SIMPLE IRA must have received compensation of at least $5,000 in the prior two years and are expected to earn that amount this year. Employers must make contributions to each participating employee’s SIMPLE IRA account, and employees can also make pre-tax contributions.
What Is a Rollover (or Conduit) IRA?
A rollover IRA, also called a conduit IRA, is a traditional IRA that meets these criteria:
- Money is deposited into the rollover IRA via a transfer from another qualified employee retirement account or another IRA.
- Only rollover money is deposited into a rollover IRA. You do not make additional contributions to the IRA or add funds from other sources.
In all other respects, a rollover IRA is just a traditional IRA. The reasons a conduit IRA exists has to do with certain tax benefits that used to apply to “pure” rollover money that has not been intermingled with contributions. Those tax benefits are now largely obsolete. However, conduit IRAs can be useful if you wish to separately track retirement funds from several different plans, such as 401(k)s or SIMPLE IRAs from different employers. The IRS allows you to own multiple IRAs, which allows you to maintain one or more conduit IRAs.
In contrast to a traditional IRA, you contribute post-tax money to a Roth IRA. You don’t receive a tax deduction for contributions, but you can withdraw contributions and earnings tax-free if you follow the rules. If you roll over pre-tax money from a traditional IRA or another qualified account into a Roth IRA, the transferred amount is included in your current taxable income. Early withdrawal penalties are always assessed when earnings (but not contributions) are distributed during the Roth IRA’s first five years. Penalties might also apply to earnings withdrawals before age 59 ½ unless they qualify for an exception.
Difference Between SIMPLE and Traditional IRA
SIMPLE IRAs differ in several ways from their traditional brethren with respect to:
- Employee contributions: As of 2018, you can annually contribute up to $5,500 of earnings ($6,500 if you’ve reached age 50) to your traditional IRA. The maximum SIMPLE IRA employee contribution is $12,500 ($15,500 for age 50+). All employee contributions are optional.
- Employer contributions: Employers cannot contribute to an employee’s traditional IRA but must contribute to each participating employee’s SIMPLE IRA. Employers can choose to make matching contributions or nonelective contributions. Matching contributions must be on a dollar-for-dollar basis with employee contributions, up to 3 percent of employee compensation. The employer can reduce the matching contributions to as little as 1 percent, but for no more than two out of five years. Alternatively, employers can make nonelective contributions of 2 percent of employee compensation (up to $275,000 in 2018), irrespective of whether or not the employee contributes.
- Early withdrawal penalties: Both traditional and SIMPLE IRAs impose a 10-percent penalty tax on withdrawals before age 59 ½ unless an exception applies. The same exception list covers both types of IRAs and includes early withdrawals due to high medical expenses, medical insurance costs when you are unemployed, disability, death, annuity distributions, higher education expenses, first-home purchases, IRS levies and qualified reservist distributions. A special rule applying to SIMPLE IRAs is that early withdrawals made in the account’s first two years are penalized at a 25- percent rate instead of the usual 10 percent. This rule doesn’t apply to early withdrawals that qualify for a penalty exception.
- Rollovers: Except for Roth IRAs, a rollover is a tax-free event as long as the funds are directly transferred from one qualified plan to another, an operation known as a trustee-to-trustee transfer. There is no limit on the number of trustee-to-trustee transfers you can perform within the same year. The transfer can also be tax-free if you withdraw from one retirement plan and deposit the full amount into another plan within 60 days. You can perform only one of these per year, no matter how many IRA accounts you own. If you miss the 60-day deadline, you will have to pay taxes on the withdrawal and may be subject to an early withdrawal penalty if you are younger than 59 ½. Any type of IRA can accept a rollover, but certain from-to combinations are not allowed. A traditional IRA can accept tax-free rollovers from all other IRA accounts except Roth IRAs, and from other qualified retirement plans such as a 401(k), 403(b) and 457. You can perform a tax-free rollover from one SIMPLE IRA to another SIMPLE IRA any time, but you will trigger taxes if you roll over from a SIMPLE IRA to a non-SIMPLE IRA during the first two years of your participation in the SIMPLE IRA plan. You cannot roll into a SIMPLE IRA from a non-SIMPLE IRA.
- Tax deductions: Your SIMPLE IRA contributions are automatically excluded from your taxable income by your employer, so you don’t have to make a special deduction on your Form 1040. If you are self-employed, you deduct your employer contributions to your SIMPLE IRA on a separate line. Contributions to a traditional IRA are deducted on their own line on Form 1040. However, certain income limits might reduce your traditional IRA tax deduction when you or your spouse were also covered by a qualified employee plan, including a SIMPLE IRA. For 2018, single filers also covered by an employer plan can take a full, traditional IRA tax deduction if their modified adjusted gross income (MAGI) doesn’t exceed $63,000. If their MAGI is in the $63,001 to $72,999 range, they get a partial deduction, but no deduction for a MAGI of $73,000 or higher. The partial deduction range for a joint filer is $101,001 to $120,999 if you are covered by an employer plan, and $189,001 to $198,999 if only your spouse is covered.