Individual Retirement Accounts, or IRAs, are valuable alternatives or supplements to 401k or 403b workplace retirement plans. Anyone who has earned income in the last year is eligible to contribute to an IRA. Currently, you can deposit up to $6,500 in your IRA account, and up to $7,500 if you are age 50 or older on an annual basis. There are two types of IRA accounts: Traditional IRAs and Roth IRAs. So, what’s the difference, and how can you decide which works best for you? In short, you pay taxes on your traditional IRA later when you take distributions, and you pay taxes on your Roth IRA now, when you make your contributions. This means that if you think you’ll find yourself with a higher tax rate later in your life, a Roth IRA may be more beneficial, while the reverse is true for a traditional IRA. It is difficult to predict your tax rate and income in retirement, especially if retirement isn’t in your near future, so it’s important to consider the pros and cons of both types of IRAs.
Traditional IRA
Pros
- The biggest benefit of a traditional IRA is reducing your taxable income in the year the contribution is made.
- Traditional IRAs are also suited for high earners because unlike Roth IRAs, there is no maximum income limit to contribute to a traditional IRA.
Cons
- You might be ineligible for the full tax break that a traditional IRA offers if both of the following apply:
- You are covered by a retirement plan at work (401k/403b).
- You have an income over $73,000 if filing as single or $116,000 if filing jointly with a spouse.
- Traditional IRAs have stricter withdrawal rules. Most withdrawals before age 59 ½ are penalized 10% on top of being taxed as income.
- You are forced to start taking required minimum distributions (RMD’s) from your account beginning at age 73 so your money will no longer be able to grow tax deferred.
Roth IRA
Pros
- The main benefit of a Roth IRA is the tax-free growth on your savings the account offers. Contributions are made with after-tax dollars, so all the distributions are tax-free!
- Roth IRAs have more lenient withdrawal rules. You can withdraw contributions you have made to the account at any time tax-free, while earnings in the account will be penalized 10% if withdrawn before age 59 ½ with some exceptions.
- Roth IRAs have no RMD’s, meaning if you don’t need the money now, you can continue letting it grow tax-free.
Cons
- The largest downside to a Roth IRA is that not everyone is eligible. Individuals with an income above $138,000 if filing as single or $238,000 if filing jointly with a spouse will have reduced or no contributions allowed to a Roth IRA.
- There is a five-year minimum for having a Roth IRA before you can withdraw earnings unpenalized. This also applies to inherited and converted Roth IRAs.
Bottom Line
A Roth IRA will be more beneficial and flexible for most people saving for retirement, as it’s likely tax rates will be higher in the future. However, every individual’s savings and retirement plans are different. It is important to consult your CPA and financial advisor before making any important decisions. Regardless of which type of account works best for you, anyone who is eligible should take advantage of the tax benefits of an individual retirement account, and contributions can be made for the current year anytime up to April 15th of the following year. Any type of retirement savings is good retirement savings, and it is never too early to start planning for your future!
- Jack McKinnell / Chris Wasson
Sources:
https://www.nerdwallet.com/article/investing/roth-or-traditional-ira-account
https://www.investopedia.com/retirement/roth-vs-traditional-ira-which-is-right-for-you/
https://www.irs.gov/pub/irs-pdf/p590b.pdf