There is a wide variety of tax-advantaged ways for individuals to save for retirement. Because of their income tax benefits and because IRAs are so easily established, they have become one of the most often used retirement savings vehicles available today. Tax laws have created two unique types of IRA’s: Traditional IRA and Roth IRA, as well as a non-deductible IRA contribution. Understanding the pros and cons of both can help you determine which IRA is right for you.
A Traditional IRA is a tax deferred retirement savings account which allows a working individual under the age of 70 1/2 to contribute up to $6,000 each year if under the age 50 ($7,000 if 50 years or older) of compensation for retirement and other important financial goals. Married couples who file jointly may contribute up to $12,000 ($6,000 per IRA), or, if each partner is 50 years or older, $14,000 as a “catch up” contribution, even if only one spouse has earned income. Traditional IRAs necessitate “required minimum withdrawals” (RMD’s) of a percentage of your funds at the age of 70 1/2. These withdrawals are subject to ordinary income tax and may be subject to a 10% federal penalty if taken prior to age 59 1/2.
A great benefit of Traditional IRA contributions is that contributions are both state and federal tax deductible – depending on participation in an employer maintained retirement plan, adjusted gross income, and filing status. Because of this deduction, if you expect to be in a lower tax bracket during retirement than you are now, a Traditional IRA may be the way for you to go.
The Roth IRA is available as an alternative to the traditional IRA. The age limitation as well as total yearly contributions is the same as a Traditional IRA. Total contributions to all traditional and Roth IRAs cannot be more than: $6,000 ($7,000 if you’re age 50 or older) per individual a year, not counting rollover contributions. A disadvantage of the Roth is the income limit (MAGI) to qualify for contributions: $203,000 (married filing jointly) and $137,000 (single filers), with a phase out starting at $193,000 (married filing jointly) and $122,000 (single filers).
The popularity of Roth comes from its tax free growth and tax free withdrawals. Although you cannot deduct your contribution from your income each year like the traditional IRA, the money you invest in a Roth will grow tax free for the time it stays in the account, and barring a few exceptions, there is no tax incurred when taking the withdrawals. This alone makes the Roth IRA the choice of many employees that begin their investing early and plan on being in a higher tax bracket at retirement age.
Earnings on a Roth cannot be taken without penalty until five years after the first contribution and only after you have reached age 59 1/2. However, you may withdraw the same amount as your contributions before the age of 59 1/2 without penalty. Since there are loopholes for early withdrawal, always consult your tax advisor for additional ways to qualify for tax-free withdrawals of Roth distributions and to avoid federal penalty. Another advantage of a Roth, is unlike a Traditional IRA, there is no maximum age mandated for withdrawal. If not needed, the funds in a Roth can be used as a potential wealth transfer vehicle for loved ones.
Unlike a Traditional IRA, a non-deductible IRA contribution is made with “after-tax” dollars, meaning the income tax deduction allowed the Traditional IRA is not available for a non-deductible contribution. This contribution also differs from a Roth as earnings are taxed as ordinary income when withdrawn. Because of this, contributing to a Roth or Traditional IRA can be far more beneficial than making a non-deductible IRA contribution. However, some earners may not qualify to contribute to a Roth or reap the deduction benefit of a Traditional IRA based on their filing status, income, or whether they or their spouse has a retirement plan at work. In this case, making a non-deductible IRA contribution may make the most sense, especially considering that they can still have tax free growth while the investment stays in the account.
Another popular use of a non-deductible IRA contribution is what has become known as the “backdoor” Roth IRA option. This allows high earners to make a non-deductible IRA contribution and then convert it to an Roth allowing their money to grow tax free. This can happen in the same year that they make the contribution. The tax implications for a backdoor IRA can be somewhat complicated, so it is important to understand all IRS rules and deadlines when making non-deductible IRA contributions or converting to a Roth.
Which IRA is Best for You?
Many factors must be considered when determining which IRA savings account is right for you. Determining current and future income tax rates, investment returns, what the money will be used for and when, income, marital status, and the availability of a retirement plan are a few of the things to look at. Use our calculators to help you to make the best investment decision by choosing an IRA that fits your needs.