It is never too early to start saving to achieve your retirement dream. One of the best ways to do that is by opening an Individual Retirement Account (IRA). An IRA is a savings account with unique tax benefits, which can help you save more money for your retirement.
IRAs account for over 34% of retirement assets in the U.S. There are two main types of IRAs: Roth IRAs and Traditional IRAs.
We’ll review the key differences between Roth and Traditional IRAs to help you make an informed decision about your retirement savings.
Roth IRA vs. Traditional IRA
Established in 1974, a Traditional IRA is an individual retirement account created to incentivize Americans to save for retirement. It offers tax-deferred growth and tax-deductible contributions, meaning you can deduct your contributions from your taxes in the year you make them. Contributions to a Traditional IRA lower your overall taxable income and, therefore, your tax bill.
IRAs are more than just a savings account, giving you the option to invest in mutual funds, individual stocks, and even precious metals and grow your money tax-deferred. You won’t have to pay taxes on the funds until you withdraw them in retirement.
Traditional IRAs are the most common type of retirement savings account. As of mid-2020, nearly 29% of U.S. households held a Traditional IRA.
Introduced in 1997 as part of the Taxpayer Relief Act, a Roth IRA is an individual retirement account offering tax-free growth and retirement withdrawals. Contributions to a Roth IRA are made with after-tax dollars, meaning you have already paid taxes on the money you contribute.
Over 26 million households owned a Roth IRA in 2020, which represents about 20% of IRA holders in America.
Tax Implications of Each
For Example, if Jim Contributes Money at Age 30 and Retires at 65, Several Tax Scenarios Will Apply.
|Deposit At Age 30||At Age 34||At Age 50||At Age 65|
|Traditional IRA||Tax-free contribution (Jim subtracts the amount from income).||Jim will pay tax on withdrawals according to his income tax bracket and pay a 10% additional tax penalty when the withdrawal is before age 59.5.||Jim will pay tax on withdrawals according to his income tax bracket and pay a 10% additional tax penalty when the withdrawal is before age 59.5.||Jim will pay tax on withdrawals according to his income tax bracket.|
|Roth IRA||Jim contributes after-tax income (Tax paid per current income tax bracket).||Jim can withdraw his original contribution tax-free, but any earnings/growth amounts withdrawn before five tax years of the first contribution to a Roth IRA are taxed as per his income tax bracket.There may be a 10% additional tax penalty as well.||Jim can withdraw his original contribution and any growth amount tax-free.||Jim can withdraw his original contribution and any growth amount tax-free.|
In general, Roth IRA gives you the flexibility to withdraw your savings at any time. Traditional IRAs allow you the benefit of a tax deduction in the current (contribution) year.
Contribution & Tax Deduction Limits
You can contribute to an IRA if you have taxable income. The Internal Revenue Service (IRS) has set some limits on the amount of money you can invest in IRAs. For 2022, this limit is $6,000 and has been unchanged since 2019. If you are over 50, you can contribute up to $7,000.
It is crucial to keep in mind that this limit is cumulative for all IRAs. While you can contribute to a Traditional and a Roth IRA in the same year, the total amount contributed to all your IRAs can not exceed the $6,000 limit in 2022.
Are There Any Required Minimum Distributions After Retirement?
Let’s go back to Jim’s example once again. At age 72, Jim must start taking distributions from his Traditional IRA holdings as per amounts mandated by the IRS, based on Jim’s life expectancy and balance remaining.
Jim has no obligation to distribute his Roth IRA holdings. He can continue to choose the best investments to grow his money tax-free.
|At Age 72:|
|Traditional IRA||Must start taking a minimum amount of withdrawals and pay tax as per income.|
|Roth IRA||Tax-free withdrawal of original contribution and any growth amount.No mandatory withdrawals.|
Tax Penalties & Early Withdrawal
The IRS has introduced exception scenarios to avoid paying the 10% penalty tax for early withdrawal from Traditional and Roth IRAs. Some of these qualifying scenarios are described below. Consult the IRS website for more details.
Source: IRS website.
Roth IRA vs. Traditional IRA For Investment
This decision comes down to personal preference, a fair guess of what your retirement income will look like, and IRS rules.
- If you believe you will be in a lower income tax bracket in retirement, it is a good idea to contribute pre-tax income to a Traditional IRA. You’ll pay income tax on withdrawals but will pay a lower tax rate versus your current rate.
- On the other hand, if you think you’ll start withdrawing funds at a higher income level at retirement than your current income, then contribute to a Roth IRA with after-tax income at your current low rate. This way, future withdrawals will not add to your income and boost your tax rate.
- Another approach is splitting your contributions between account types to hedge your risk.
- Do you need immediate tax relief? If you underestimated your income in the current year or expect a significant windfall, taking the immediate tax deduction with a Traditional IRA contribution may be beneficial.
Finally, IRS rules stipulate income levels over which you can not qualify to contribute to a Roth IRA. Income levels also govern whether you can deduct Traditional IRA contributions from your income. These rules laid out below may decide for you.
Traditional IRA Allowable Deduction Scenarios
- If a retirement plan at work does not cover you (and your spouse), you can deduct the total amount of your contribution to a Traditional IRA.
- Specific income levels do not qualify for a deduction if a retirement plan at work covers you or your spouse. For example, you cannot deduct any amount if married and make over $129,000 a year. On the other hand, if you make less than $109,000, you can take a full deduction. Refer to this page on the IRS website for a complete list of income-level-related rules.
Roth IRA Allowable Contribution Limit Based on Income
Similar to income-based deduction limits for a Traditional IRA, your income determines whether you can contribute to a Roth IRA.
- For example, if you are married and make more than $214,000 a year, you can not contribute to a Roth IRA. You can contribute up to the limit if you make less than $204,000.
- If you are single and your income is less than $129,000, you can contribute up to the limit. On the other hand, if you make more than $144,000, you can not contribute to a Roth IRA.
Refer to the IRS website for a complete list of qualifying income levels for a Roth IRA.
Convert a Traditional IRA to a Roth IRA
You may be able to convert your Traditional IRA to a Roth IRA. Converting to a Roth IRA can be a good option if you expect to be in a higher tax bracket when you retire or if you want the flexibility of having both taxable and tax-free income in retirement. This is called a backdoor Roth.
To convert your Traditional IRA to a Roth IRA, you must pay taxes on the money you convert. The converted amount gets added to your taxable income for the year, and you will owe taxes at your marginal tax rate.
Before converting your Traditional IRA to a Roth IRA, you must speak with a financial advisor to see if this is the right move. They can help you weigh the pros and cons of conversion and help you decide if it’s right for your financial situation.
Start Your Annual Contributions Today
Deciding between a Roth IRA and Traditional IRA depends on your financial situation and retirement goals. Both types of accounts have their benefits, so weighing the pros and cons before deciding which one is right for you is essential.
If you’re still unsure which type of account is right for you, speak with a financial advisor who can help you make an informed decision about your retirement savings.
This article originally appeared on Wealth of Geeks.