It's tax time. Which means it is also IRA time.
Are you experiencing some serious FOMO (Fear of Missing Out) when it comes to choosing between a Traditional IRA and a Roth IRA? Don’t worry, you’re not alone!
Let’s dig into what things you need to consider when deciding between the two, but first, we’ve got to cover the basics.
IRA 101
Pop Quiz: What does IRA stand for? I bet you get it wrong! Nope, that “A” does not stand for Account. Or Annuity. IRA actually stands for Individual Retirement Arrangement!¹ That’s your fun fact for the day. Now on to the good stuff.
Assuming you qualify, you can contribute to an IRA anywhere from January 1st through the tax filing date for that year (which for 2022 is 4/18). So while you could technically knock this off your to-do list early on, most people wait until tax time. Why? Usually for one of two main reasons. First, if cash is tight, they want to see how the year plays out financially to assess whether or not they have the extra cash to put towards retirement. After all, saving for retirement is great, but if the car needs a major repair or the refrigerator dies, you’ve got to take care of those first. Second, for those with higher income levels, they need to see if they qualify.
The IRS has very specific rules regarding the amount you can contribute and whether you can contribute at all. Let’s look at some common features, and then at each IRA in turn.
Rules for both Traditional & Roth IRAs
Contribution Limits
For 2023, the contribution limit is $6,000 for those under 50, and $7,000 for those aged 50 and over. You can have both kinds of IRA’s and contribute to both in one calendar year, but the combined TOTAL contribution cannot exceed these limits. So if you are 45 and you qualify (more on this below), you could make a $3,000 contribution to a traditional IRA and another $3,000 contribution to a Roth for 2022.
Tax Shelter
All earnings are sheltered from taxes. Earnings (and contributions) from deductible Traditional IRAs will be taxed as ordinary income at withdrawal (and potentially penalized if withdrawn before age 59.5). Earnings (and contributions) from Roth IRA’s will be tax free as long as the account has been open for at least 5 years and you are over age 59.5.
Age Limit
There used to be rules saying you could not contribute to IRAs after age 70.5. This has changed and since 2020 there is no age limit for both Traditional and Roth IRA contributions.
Income Requirement
While there is no age limit for contributions, there is an income requirement. You cannot contribute to an IRA unless you have EARNED income. This is generally W-2 and self employment income. Income from rental properties, investments, pension or annuity income does not count.
investments
You choose the investments that go inside an IRA. They can vary widely.
Fees
The accounts themselves typically do not have fees. The fees are usually assessed on the investments you select within the IRAs.
Withdrawal Rules
The magic age for IRA withdrawals without penalty is 59.5 years old. Generally, if you try to withdraw anything from traditional IRAs or the earnings from Roth IRAs prior to that, you may be subject to an early withdrawal penalty of 10% in addition to ordinary income tax. There are some “triggering events” that allow you to avoid that penalty and/or taxation. The specifics are big enough to be a full post on their own so I won’t get into them here but refer to the IRS website to learn more about that.²
Inheritability
IRAs are fully inheritable. There are specific rules about how long your beneficiaries can keep their investments inside the tax sheltered accounts once they have inherited it, depending on who they are in relation to you. Make sure to update your beneficiaries on all accounts.
Traditional IRA Rules
Here are some unique rules for Traditional IRAs to consider.
Contributions & Deductibility
Traditional IRA contributions are deductible against your income, which essentially converts your after tax contribution into pretax (you get the taxes you paid on that contribution back in your tax return for the year you made the contribution). That means that when you withdraw the funds you will pay ordinary income tax on both the earnings and the contributions (and potentially a penalty if you withdraw before age 59.5).
It is important to note that if both you and your spouse are NOT covered by an employer retirement plan (meaning your employer either does not have one available or you do not qualify to participate in it) then you are always allowed to make the full IRA contribution and it will be fully deductible no matter how much income you make. If either you or your spouse are covered by an employer retirement plan, then you are still subject to the income limitations.
Not everyone can deduct their contributions. If you have the option to invest in an employer based retirement plan, then you can fully deduct your contribution if your Modified Adjusted Gross Income (MAGI) is below $68,000 for a single filer and $109,000 if you are married, filing jointly.³
If your MAGI is above those limits, your deductibility begins to phase out. Once it is above $78,000 for single filers and $129,000 for married filing jointly filers, you can no longer deduct the contribution.⁴
Your MAGI is your adjusted gross income that includes certain tax deductions and exclusions, such as Traditional IRA contributions, student loan interest, and others. Don’t worry too much about calculating your MAGI on your own. If you use tax software it automatically calculates it for you.
If you are not eligible to deduct your contribution, you can still MAKE the contribution but you get no current year tax benefit. If you choose to do that, either invest your non-deductible contributions separately from your deductible IRA investments or track them VERY CAREFULLY so you are not double-taxed when you withdraw in retirement. Your earnings are still tax sheltered until you withdraw and will be taxed as ordinary income when you do pull them out, but your contributions will be returned income tax free as long as you can prove that you did not get a tax deduction for them.
Withdrawals
Upon withdrawal after age 59.5, assuming these were deductible contributions, you will pay ordinary income tax on both earnings and contributions. If you withdraw prior to age 59.5 you will likely pay tax and a 10% early withdrawal penalty. Again, there are some triggering events that avoid that – see the www.irs.gov for specifics on those rules.
Traditional IRA’s are subject to required minimum withdrawals once you hit age 72. An RMD is an amount that the government says you have to take out and pay taxes on. They do not care what you do with it – spend it on whatever you want or reinvest it, as long as it does not get reinvested back into a tax sheltered account (unless you are still working and can legally make a traditional IRA contribution – but you would likely need a new IRA account for that contribution). Technically, your first RMD must be taken by 4/1 of the year following your first year of qualification (the year you turned 72). However, if you delay taking this RMD until that point, you still have to take a second one that calendar year.
Roth IRA Rules
Now lets look at rules for Roth IRAs.
Contributions
Roth IRA contributions are made after tax so that when you withdraw the money (after holding the account for 5+ years and over age 59.5) both the contributions and earnings are income tax free. That is VERY attractive to a lot of people.
With Roth contributions you don’t have to worry about deductibility rules – but you do have to worry about income qualifications. Once your MAGI is $138,000 for a single filer and $218,000 for married filing jointly you begin to phase out the amount you can contribute. When your MAGI hits $153,000 for single and $228,000 for married filing jointly, you can no longer contribute.⁵
For those that want Roth but do not qualify, there is a way to do this at the moment called a Backdoor Roth. I will be posting all about that next week, so stay tuned!
Withdrawals
A huge perk of the Roth IRA is the ability to withdraw your contributions at any point, for any reason. Some people like to use that as their backup to their emergency savings account. The earnings are not so easy to withdraw. To learn the specifics about Roth IRA withdrawals (and really ALL the IRA rules) check out IRS Publication 590 which is the real rulebook for IRA’s – this you can trust – be careful reading other companies articles about IRA’s. When you can, go to the source. 590-A focuses on contributions and 590-B on withdrawals.⁶
Another perk for Roth IRAs is that they do NOT have required minimum distributions. Technically you are never forced to take a distribution. This also makes them an attractive asset for beneficiaries to inherit.
So how do i pick the right one for me?
Choosing between a Traditional IRA and a Roth IRA can feel like trying to decide which breakfast you want. You could choose just to have coffee or make yourself some avocado toast. Both are delicious, but it is all about personal preferences and what you want to get out of it.
A Traditional IRA is like a steaming cup of coffee. It’s been around for a while and is always a crowd-pleaser. You get a tax deduction for your contributions, just like the delicious smell fills the room every morning. But just like how you might feel a little unfilled with JUST coffee, you’ll have to pay taxes on your withdrawals in retirement.
A Roth IRA is more like trendy avocado toast. It may be a newer option, but it’s packed with benefits. There’s no upfront tax deduction, just like there’s no boost of caffeine in your avocado toast, but it is a guilt-free option that will pay off in the long run. The money grows tax-free, so you won’t have to pay taxes on your withdrawals in retirement. Plus, you get the added bonus of feeling hip and trendy just like ordering avocado toast at a fancy brunch spot.
It’s worth noting that you can always have both. You can contribute to both a Traditional and a Roth IRA as long as you stay within the annual contribution limits. I mean, who doesn’t want coffee with a healthy treat in the morning? Diversifying your income sources in retirement is great – you get the best of both worlds.
Here are some important factors for you to consider when making your choice:
Current & future tax brackets
The true difference between Traditional and Roth is taxes. To decide which is better, ask yourself these questions: do you see yourself replacing a similar level of income in the future, so that you will fall into a similar tax bracket? Do you see yourself living on less in retirement, so falling into a lower bracket? If you see yourself in a similar or higher bracket in the future, you might prefer Roth contributions now. You need to look at your current retirement balance, your time horizon, your asset allocation, and your savings rate to assess if you are on track to replace your income in retirement.
Many people find themselves in lower tax brackets earlier on in their career due to lower incomes and the tax deductions that come from having a large mortgage and young children. These people lean toward Roth. Conversely, those near the end of their career are typically in the highest tax brackets of their lives and usually have little to no tax deductions. These people typically believe they will fall into a lower bracket in the future so they are better served taking a tax deduction now by contributing pre-tax.
Current & future tax rates
In addition to considering where you will fall into the tax brackets in retirement, you also need to think about where you believe tax rates might go in the future compared to where they are today. If you feel that overall tax rates will be higher in retirement, then you might prefer to pay them now by making Roth contributions.
Time horizon
Roth provides the opportunity for tax free growth, so the more time you have and the more risk you are willing to take, the more advantageous Roth will be. Those comfortable with a more aggressive asset allocation (higher percentage of their portfolio in stocks) tend to prefer having those assets in Roth as all of that growth could be returned to them income tax free.
Desire to diversify income sources in retirement
The law does not allow employers to contribute Roth so anything they contribute on your behalf is pre-tax. If you want access to some money in retirement that you can withdraw without income tax, then consider making some Roth contributions.
Access to funds
If you want the peace of mind of knowing that you can withdraw your contributions at any point, then you may prefer Roth contributions.
Loss of use
Some people decide to front load Roth IRAs when they can because they believe their income will increase to the point of no longer being able to contribute to the Roth IRA quickly and they prefer to use them as much as possible while they can. This can be true but also remember that many people have access to Roth via their employer based plans. In addition, at least for the moment, there is also access to Roth via the “backdoor”. Another post to come on that!
There is no right or wrong answer
Ultimately, choosing between a Traditional IRA and a Roth IRA is about finding the right fit for you. It is all about understanding your own needs and preferences. Do your research, weigh your options, and be proud of the fact that no matter which you choose, you are saving for your future – and that is what matters the most.
Resources
All information in the blog posts is for informational and educational purposes only. The information and education provided is not intended or implied to supplement or replace the professional advice of an attorney, accountant, and/or financial advisor. You should consult a professional in those areas (financial, legal, accounting, etc.) where you live or work to discuss issues or questions pertaining to your particular legal, financial, or business situation. In addition, although we do our best to be accurate and up to date, we cannot guarantee that all of our content is up to date at all times and is completely accurate. Please contact us with any updates that need to be made at hello@financiallearninggroup.com. THANK YOU!
