Stocking Your Financial Planning Toolbox: Traditional & Roth IRAs
*Updated March 14, 2022
If you’ve ever started a DIY project, you know that one of the keys to success is having a well-stocked toolbox. Having the basics like a hammer, screwdriver and tape measure can get you pretty far. Add in a few more tools like a power drill and a handsaw and suddenly you can tackle even more!
Saving for retirement is no different. Having a well-stocked toolbox is key and you will likely want to use a variety of tools throughout the process. One of the best tools to consider “purchasing” for your toolbox is the Individual Retirement Account (IRA). And, just as there are variations to each basic tool (you wouldn’t want a Phillips head screwdriver when the job calls for a flathead), there are various types of IRAs that an investor should consider. Today we will focus on two types of IRAs: Traditional and Roth.
But first, why should you consider funding an IRA?
IRAs give you the opportunity to save and invest in a tax-advantaged way. Investments within IRAs grow tax-free, even as dividends and interest are earned and investments are bought and sold.
What is the main difference between Traditional & Roth IRAs?
Contributions to Traditional IRAs are typically made with pre-tax dollars: initially you will use after-tax dollars (e.g., dollars in your bank account) to fund the contribution, you then may be able to deduct those dollars on your income tax return, effectively converting them back into pre-tax dollars. Traditional IRA contributions grow tax-deferred until they are taken out of the IRA, at which time you will pay ordinary income tax on anything taken out (note: withdrawals must be taken after age 59 ½ to avoid penalty). Contributions to Roth IRAs are made with after-tax dollars. Those Roth IRA contributions then grow tax-free and remain tax-free even when you take the money out (assuming that, at the time the money is withdrawn, you are at least 59 ½ years old and the Roth IRA has been open for at least five tax years).
What about required minimum distributions?
A required minimum distribution (RMD) is the amount that you are required to withdraw annually from your IRA. There are no RMDs from your Roth IRA while you are alive, but RMDs from Traditional IRA are required at age 72, unless you turned 70 ½ in 2019 or earlier.
So then, which is better, a Traditional or Roth IRA?
There are benefits to both, and you don’t have to exclusively use one option over the other. Contributing to a Traditional IRA will give you a tax break right away, whereas the tax benefits of a Roth IRA aren’t realized until later. Generally, those in lower tax brackets and/or a long way from retirement may benefit more from Roth IRAs, whereas those in higher tax brackets and/or closer to retirement may benefit more from Traditional IRAs.
How much can I contribute?
If you are considering making an IRA contribution, keep in mind that you cannot contribute more than you earned in a year. In addition, the IRS sets forth annual contribution limits; for 2021 and 2022, total contributions to your Traditional and Roth IRAs combined cannot exceed $6,000 for those under age 50 or $7,000 for those age 50 or older. In the past, individuals age 70 ½ and older were only permitted to contribute to Roth IRAs but, for tax years beginning after 2019, as long as you have earned income you can contribute to a Roth or Traditional IRA at any age (thank you SECURE Act). There are income thresholds that can reduce IRA contribution and deduction limits if you are covered by a retirement plan at work. Permissible Roth IRA contributions also may be reduced or eliminated if your modified adjusted gross income reaches a certain threshold, even if you are not covered by a retirement plan at work.
As Anthony T. Hincks once said, “Make sure that you always have the right tools for the job. It’s no use trying to eat a steak with a teaspoon and a straw.” Each investor’s situation, like a DIY project, is different. We are here to help you use the right tools, like IRAs, for the job.
Your tax professional can help you determine your eligibility to make an IRA contribution. If you have any questions about Roth or Traditional IRAs, or any other retirement savings vehicle, please let us know.