As we get older, we hear about the importance of setting up an IRA or Roth IRA, but it’s hard to do so when you know little about what they are and what they offer. Let’s explore if you might benefit from such a retirement account, learn the difference between the two, and discover which IRA may be best for you.
What is a traditional IRA?
A traditional IRA (Individual Retirement Account), first established in 1974, allows you to direct pre-tax income toward investments that can grow tax deferred. An IRA protects your funds from capital gains or income taxes until you make a withdrawal. Individual taxpayers are allowed to contribute 100 percent of any earned compensation up to certain specified amounts depending on your age. This means that you can only contribute to an IRA if you work. If you have already retired, an IRA is not for you.
Additionally, your contributions to a traditional IRA may be tax deductible depending on your income, tax-filing status, and other factors. This means that contributions made will also generally lower your taxable income during the contribution year which in turn lowers your adjusted gross income. This allows you to qualify for more tax incentives you wouldn’t otherwise get (such as the student loan interest deduction and child tax credit).
Once you retire, withdrawals from the account are taxed at the IRA owner’s current income tax rate. However, if you decided to withdraw money from your IRA before the age of 59 ½ you will have to pay taxes as well as an early withdrawal penalty of 10%. You can avoid the penalty in some specialized circumstances but will still have to pay taxes on it no matter what. This means you want to avoid tapping into your IRA early, which is okay, because this is a retirement saving option, right?
What is a Roth IRA?
A Roth IRA, first established in 1998, is a type of tax-advantaged individual retirement account that you can contribute after-tax dollars to. The most common reason why these accounts are so popular is due to one primary benefit: your contributions and earnings on those contributions can grow tax-free and be taken out tax-free after the age of 59 ½ (assuming you have had the account for at least five years). Additionally, Roth IRA accounts are best when you believe your marginal tax rate will be higher in retirement than they are currently.
Unlike traditional IRAs, you will not receive a tax deduction for making contributions to your Roth IRA. This means that it does not help to lower your AGI; however, your withdrawals from your Roth IRA during retirement will be tax-free (this is due to you paying the tax bill initially). However, you are allowed to withdraw sums equivalent to your Roth IRA contribution at any time tax- and penalty-free, even before the age of 59 ½. This can be an advantage in an emergency, but again, the purpose of this account is to save for retirement.
Like traditional IRAs, you need earned income to contribute to a Roth IRA. If you file single, you can contribute up to 100% of the maximum annual contribution if you earn up to $129,000; if you earn between $129,000 and $144,000 your contribution will be reduced pro rata; and, if you earn more than $144,000, you cannot contribute at all. If you are married filing jointing, you can contribute 100% up to $204,000; if you earn between $204,000 and $214,000 your contribution will be reduced pro rata; and, if you earn more than $214,000, you cannot contribute at all. These income limits tend to change every year or so.
Roth IRAs also do not require any minimum distributions (known as RMDs) in retirement, which means that you do not have to withdraw any money ever unless you want to. Once you reach age 72, you are required by the IRS to take an annual (minimum) distribution from your traditional IRA; the reason for this is that the IRS wants to begin collecting the taxes that you have been deferring all those years.
Can I have both a traditional IRA and a Roth IRA?
Yes, you can contribute to both types of IRA accounts if you meet the specific contribution requirements. You are allowed to contribute a maximum of $6,000 ($7,000 if you are 50 or older) annually to one or both IRAs. For example, if you were 49 years old, you could contribute $3,000 pre-tax to your IRA and $3,000 after-tax to your Roth. Contribution limits tend to increase every few years.
Which should you choose?
Deciding which IRA to choose is solely based on your situation. In either case, you must have earned income. If you need the tax-deduction, a traditional IRA may be your best option. On the other hand, if you like the idea of tax-free growth and tax-free withdrawals, with access to your contributions with no restrictions, a Roth IRA may be your best option. Of course, as explained, you can also have both. Talk to you banker or investment advisor before you make a final decision.