First off, what is an IRA? An Individual Retirement Account (IRA) is a tax structure. It is not an investment. When you say you have an IRA, I can tell you how the money you have contributed was taxed and how it will be taxed. Saying you have an IRA does not tell me how you are invested. One person could have an IRA invested in nothing but stocks while another person with an IRA could have their money invested in nothing but bonds. So, when you think IRAs – think taxes.
Types of IRAs
There are 4 types of IRAs: Traditional IRA, Roth IRA, SEP-IRA, and Simple IRA. Traditional IRAs and Roth IRAs are used by individual investors. SEP-IRAs and SIMPLE IRAs are employer sponsored plans used by small employers. We’re going to focus on IRAs for individuals.
A Roth IRA is a retirement account that offers tax-deferred growth and tax-free withdrawal in retirement. Money you contribute to your Roth IRA is made with after tax dollars – meaning you have already paid the taxes on the money you put in the Roth IRA. You don’t get a tax break now, but you get tax free distributions in retirement.
On the other hand, a Traditional IRA allows you to contribute with pre-tax dollars. That means you get to deduct your contributions from your current income, which can lower your overall tax burden for this year. Like a Roth IRA, the funds grow tax-deferred. However, any amounts taken out of the Traditional IRA will be taxed upon withdrawal. Every dollar you take out of a deductible Traditional IRA will be taxed during retirement.
Roth IRA vs. Traditional IRA
There are key differences between Roth IRAs and Traditional IRAs such as differences in timing of taxes, contribution eligibility, withdrawal flexibility, and penalties. Here’s a list of key differences between the IRAs that can help you make an informed decision.
- Timing of taxes – with a Roth IRA you pay the taxes now, but distributions during retirement are tax free. With a Traditional IRA, you take a tax deduction now, but every dollar is taxed when you distribute or take out money during retirement. Both IRAs grow tax deferred.
- Contribution eligibility – The amount of contribution is the same for Roth IRAs and Traditional IRAs. In 2022, You can contribute up to $6,000 if you are below 50 years old and up to $7,000 if you are 50 years or older. That extra $1,000 is called a catch up contribution. A Roth IRA has an income limit for direct contributions. If you make above a certain income threshold, you cannot contribute directly to a Roth IRA (see more about this below). Anyone can contribute to a Traditional IRA. However, your income and/or your eligibility to participate in an employer retirement plan (e.g. 401(k) plan) can limit or eliminate your ability to make deductible contributions to a Traditional IRA. If you are above the income limit, you can still contribute, but it won’t reduce your current taxes. Plus, you will have to keep track of how much in your Traditional IRA was taxed so when you get to retirement you don’t get taxed again!
- Withdrawal penalties – Congress really wants you to save for retirement, which is why you get these amazing tax benefits. But with those benefits comes restrictions. There is an early withdrawal penalty of 10% if you withdraw money from either type of IRA before the age of 59½. The Roth IRA also has a 5-year holding period to consider. This 10% penalty is in addition to any taxes you will pay for your Traditional IRA distributions. Both types of IRAs do permit an exception to the penalty for certain types of distributions such as for first time home purchases.
- Withdrawal flexibility – However, you can take your Roth IRA contributions out at any time without penalty. If you take out the earnings before age 59½ or meeting the 5-year holding period, you may face that 10% early withdrawal penalty.
Anyone can open a Roth IRA as long as you have earned income. Age is not a factor. If you are still working at 100, you can contribute to your Roth IRA! However, your income may prevent you from contributing to a Roth IRA. To determine your income eligibility, you need to calculate your Modified Adjusted Gross Income (MAGI). In 2022, if you are single and your MAGI is greater than $144,000, you cannot contribute to a Roth IRA. If you are married filing jointly, then your MAGI must be less than $214,000 to contribute to a Roth IRA. The IRS usually changes these numbers every year, so be sure to keep your eye on this moving target!
While there are income limits on direct contributions to a Roth IRA, currently there are no income limitations for individuals who wish to convert their funds from a Traditional IRA to a Roth IRA. So, you might still be able to make a Roth IRA contribution by first making a nondeductible contribution to your IRA and then converting it to your Roth IRA. Some people refer to this as a backdoor Roth IRA. Be sure to talk to your CPA and financial advisor before you dive into this strategy.
As for Traditional IRAs, any person regardless of age or income status, is eligible to contribute. The SECURE Act changed the age rules, so now you can contribute at any age as long as you have earned income! Just keep in mind that, upon retirement, the amounts withdrawn will be taxed at your normal income tax rate. Also, keep in mind that if you are eligible to participate in an employer sponsored retirement plan such as a 401(k), you may be limited on making deductible contributions to your Traditional IRA. Traditional IRAs also force you to take distributions out at some point during your life. When you turn 72, the IRS requires you to take out Required Minimum Distributions each year or face a steep penalty – 50% of what you should have taken out!
Which is better?
Like most issues in finances, there isn’t a right or wrong answer to this question. The major difference between Traditional IRAs and Roth IRAs is when you pay your taxes. The IRS will always take their cut, it is just a matter of when. With a Traditional IRA you get your tax savings now, but with a Roth IRA you get your tax savings later.
When deciding which is better for you, consider your current tax rates. If you are in a very high tax bracket and expect your tax rate to be lower in the future, making a deductible contribution might be more useful to you now. If you are already in a relatively low tax bracket and think your tax rate won’t change much in the future, a Roth IRA may be better for you.
What makes this hard to accurately predict is we have no idea what tax rates will be in the future. Congress can change them at any time. Given our current deficit spending, I would not be surprised if we see higher taxes in the U.S. in the future. Also, do not automatically assume you will be in a significantly lower tax bracket during retirement. During retirement you often do not have the same kinds of deductions you did when you were younger. Also, many people hope to maintain a similar lifestyle during retirement, which means they will need an income that is much like their current take home pay. For those who plan correctly, your income is not likely to drop off a cliff during retirement.
Finally, unless you save the tax savings you generated from making a deductible contribution to an IRA, you will have the same balance at retirement as a person making an after tax Roth IRA contribution. If one person saves $1 in a Traditional IRA and another person saves $1 in a Roth IRA in the same investments, they will have the same amount in their retirement accounts. The big difference is the taxes they will pay during retirement when they take distributions. The person needing to take $1 out of an IRA for retirement income will have to pay taxes on that dollar. If they pay a combined 25% tax rate, for each $1 they take out during retirement, they will only have 75¢ to spend. That means they will either have less money to spend each year, or they will spend down their Traditional IRA faster than their Roth IRA counterpart. The person taking $1 from their Roth IRA during retirement gets to keep and spend that entire $1 without having to give any of it to Uncle Sam for income taxes.
Your tax advisor is likely to steer you to a Traditional IRA because it saves you money now. They are usually focused on reducing your income taxes in any given year. But a holistic financial planner who looks at your total financial plan might be able to show you how to save taxes over your lifetime, not just this year. So unless you really need the extra income today to support yourself, you are in one of the highest income tax brackets, or are able to save your tax savings from making a deductible Traditional IRA contribution in a separate account, the Roth IRA may be a better choice for you in retirement.
Can I contribute to a Roth IRA and a Traditional IRA at the same time?
Considering how beneficial IRAs are for retirement purposes, you might want to take advantage of both options to their fullest by contributing to both. But is it really possible to have two IRAs at the same time?
The answer is yes – but with a catch! You can contribute to as many IRAs as you want as long as the IRS threshold is not exceeded in any given financial year. You can only contribute your total IRA maximum once per year. For example, if you are under 50 years old in 2022, you cannot contribute $6,000 to a Roth IRA and $6,000 to a Traditional IRA. But, you could contribute $3,000 to each.
Don’t forget you can also contribute to both your employer sponsored plans such as 401(k) or 403(b) accounts and a Roth IRA or Traditional IRA. Just remember, depending on your income, your Traditional IRA contributions may be limited for deductibility purposes if you are eligible for that employer sponsored plan.
The bottom line
IRAs help provide peace of mind, growth for retirement and tax advantages–making them a cornerstone for most (if not all) retirement plans. Not every investment vehicle offers the powerful tax advantages of IRAs. These tax advantages can help your money work that much harder for you. Although IRAs do have limitations relating to contribution limits, eligibility, and early withdrawal penalties, they have the added advantage of tax-deferred growth and either tax savings on contributions or distributions. Choosing between a Roth IRA and a Traditional IRA is often dependent on your long term goals and your total financial plan. Be sure to talk to a CERTIFIED FINANCIAL PLANNER™ professional to help make an informed decision that aligns with your specific needs, long term financial goals and approach to retirement. Contact us today if you need help figuring out what would be best for you!
