Roth IRA and Traditional IRAs: Things You Need to Know
Whatever stage of life you're in, it's not too soon to start planning for retirement. Several investment vehicles can help you leave your career and reach retirement safely.
In addition to basics like a paid-off mortgage and a debt-free lifestyle, Americans can save for retirement through tax advantaged retirement plans, such as your employer 401(k), an Individual Retirement Account (IRA), or a Roth IRA.
A 401(k) is an employer-sponsored retirement vehicle. Many employers offer a 401(k) to their team members, and some match employee contributions dollar for dollar up to a certain percent. These accounts are easy to set up, as your employer does most of the “heavy” lifting for you, and saving becomes automatic through deductions from your salary. Many Americans rely on them for retirement savings.
While a 401(k) might be the backbone of your retirement plan, you may be able to further maximize your savings and tax advantages by opening an IRA, a Roth IRA, or both. It’s important to note, though, there are maximums and may be limits based on your income.
Let's take a look at these individual retirement accounts so you can determine which of these two types of IRAs — if either — is right for you.
What Is a Traditional IRA?
Similar to a 401(k) plan, A traditional Individual Retirement Account (IRA) allows an investor to fund the account with pre-tax dollars that will grow tax-deferred. Taxes get assessed when the investor withdraws the money from the account, usually after retirement.
For 2021 people under age 50 can deposit up to $6,000 per year, and people over 50 can bump that amount up to $7,000. Not everyone can make and deduct an IRA contribution, however. If you are eligible for an employer-sponsored plan and single and your MAGI (modified adjusted gross income) is more than $66,000, you’ll only be entitled to a reduced deduction. If it’s $76,000 or more, you’re not eligible for an IRA deduction at all. For someone married these amounts jump up to $105,000 to $125,000. However, if you are not eligible for an employer-sponsored plan limitations don’t kick in until earning $198,000.
At age 59 ½ an individual can take withdrawals penalty-free, and after age 72, they must start taking a minimum annual withdrawal (referred to as a Required Minimum Distributions or RMDs).
The Benefits of a Traditional IRA
An IRA will help keep your investments in stocks, bonds, mutual funds, or ETFs exempt from taxation as long as they remain in the account. For example, if you sell a stock, your profit will not get taxed. If one of your stocks earns a dividend, that money, too, is tax free until you take it out of the account.
In addition to the tax benefits, an IRA offers some withdrawal opportunities that a 401(k) might not. You can remove cash from an IRA to pay for education expenses or a first-time home purchase without incurring a penalty, however you will pay income taxes on the amount withdrawn. There are limitations to this, so you’ll want to talk with your CPA before taking any withdrawals.
The Potential Drawbacks of a Traditional IRA
IRAs come with strict income restrictions and contribution limits. In 2021, those who are eligible to contribute are limited by $6,000 if under the age of 50 and $7,000 for those age 50 and up. In addition, traditional IRAs require investors over age 72 to make regular withdrawals from the account or face stiff penalties.
What Is a Roth IRA?
Similar to a traditional IRA, a Roth IRA is a special retirement account that offers investors select tax advantages. Key differences between these two kinds of IRAs, however, make a Roth IRA the clear choice for some.
When you invest in a Roth IRA, you pay income taxes on the money contributed to the Roth IRA in the year you fund your account. Future withdrawals, assuming they are qualified distributions, are tax-free. For a Roth IRA withdrawal to be considered a qualified distribution:
The Roth account needs to have been open for at least 5 tax years (counted from January 1st)
You’ll need to be either be at least 59 ½, permanently disabled, or withdrawing money for a first-time home purchase.
So if you choose a Roth, you pay income taxes now but not later. Meaning all the growth within the IRA is tax-free. If you choose a traditional IRA, you pay taxes later but not now.
The Benefits of a Roth IRA
A Roth IRA offers more flexibility than its traditional counterpart. Unlike a traditional IRA, you can withdraw your contributions to a Roth at any time without penalty. You will, however, get penalized if you decide to withdraw your earnings before age 59 ½ unless it is for a qualifying reason (such as higher education expenses or $10,000 for first time home buyers). It’s important to check with your CPA or financial advisor to confirm your withdrawal qualifies and accounts for any additional rules surrounding funds from a Roth Conversion.
You also have more options with a Roth after you reach retirement age. And unlike the required minimum distributions that you must take out of a traditional IRA once you've reached 72, you can leave your money in a Roth until you choose to remove it.
The Potential Drawbacks of a Roth IRA
Although many American investors choose a Roth IRA, this retirement vehicle does have some disadvantages.
For one, the income restrictions on a Roth can be tight. For another, the maximum contribution is low — $6,000 for people under 50 and $7,000 for people 50 and older. That's the same as a traditional IRA but more restrictive than some other retirement savings options.
Also, you pay taxes upfront on a Roth. For most people, this is a benefit, not a drawback. However, if you’re in a higher tax bracket now than you might be in the future this may not be the case. You should consult with your financial advisor so you know what the tax implications will be for you.
Moreover, people with a modified adjusted gross income (MAGI) that exceeds the income limit may not be able to contribute to a Roth IRA at all.
As of 2021, married joint-filing taxpayers must earn a MAGI under $198,000 per year to fully fund an IRA. Investors who earn between $198,000 and $208,000 may partially fund their account. Those earning above $208,000 may not contribute to a Roth IRA at all. The numbers differ for taxpayers who are single and those married and file separately.
Which Should you Invest in? - Key Differences Between a Roth and a Traditional IRA
Both individual retirement vehicles let American investors put their dollars into tax-advantaged accounts.
A Roth IRA lets you make after-tax contributions. A traditional IRA lets you make pre-tax contributions. So a Roth IRA can be a good option for younger people and those who anticipate being in a higher tax bracket when they retire.
Contributions in a Roth grow tax free while those in a traditional IRA grow tax deferred. The Roth offers a tax benefit later; while contributing to a traditional IRA can provide a tax benefit now (lowering your current year's tax bill).
A Roth does not have mandatory distributions, but a traditional IRA requires investors older than 72 to make regular withdrawals.
Could a traditional IRA or a Roth IRA account help you reach your retirement goals quicker? Contact a financial advisor at Cooke Wealth Management. We can help you decide what kind of IRA is the best fit for you and your retirement needs.