Traditional vs. Roth IRA: Which is Right for You?
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We all know the importance of saving for retirement. This can help us maintain a certain standard of living once we’re no longer working, essentially creating the future we want. And when it comes to saving, the best advice is to START NOW. This gives compound interest more time to work.
Some people use an employer-sponsored 401(k) to save for retirement, where they can save and invest a portion of their income. Fund are taken directly out of their check, and they might even qualify for a match program.
But while convenient, a 401(k) isn’t an option for everyone. For example, you might be self-employed or your job might not offer one. And even if you have a 401K, you might look for ways to supplement your retirement savings.
This is where an IRA, or an individual retirement account, comes into play. But how does an IRA work?
Here’s the simplified explanation to help you decide whether these accounts are right for you.
Keep in mind that there are different types of IRAs. For today, though, the focus is on a Roth and a traditional since these are the two main types.
What is an IRA?
So, right off the bat an IRA is a tax-advantage investment account that lets you save for retirement. The difference between these accounts and a 401(k) is that employers offer the latter, whereas the former is an account you set up on your own through either a bank, a brokerage firm, or another financial institution.
Now, a key difference between a Roth and a traditional IRA lies in the timing of your tax advantage.
If you open a traditional IRA, you might be able to deduct your contributions each year based on your income and tax filing status. In which case, you’ll owe taxes when you withdraw the money in retirement. Your income in the year of the withdrawal determines your tax rate.
You don’t deduct contributions with a Roth IRA, so you’re able to enjoy tax-free withdrawals in retirement (as long as you’ve had the account for at least 5 years and you’re 59 1/2). So if you think you’ll be in a higher tax bracket when you retire, a Roth IRA might be the better choice.
IRA Maximum Annual Contributions
For 2021, the max you can contribute to both a traditional and a Roth IRA is $6,000 per year, or $7,000 if you’re age 50 or older.
If you decide to open a Roth and a traditional IRA for the purpose of tax diversification, keep in mind that the annual limit applies across all of your IRA accounts.
So if you want to contribute the maximum $6,000 to both a traditional and a Roth, you might split your contribution and put $3,000 into a Roth and $3,000 into a traditional.
Other things to know about IRAs
Be mindful, too, you can only contribute earned income to an IRA. But this doesn’t mean you’re ineligible if you don’t work. There’s also the option of a spousal IRA. This allows a working spouse to contribute to an IRA on behalf of a spouse who doesn’t work or who earns little money.
And while we’re on the subject of income, your income also determines which IRA option is right for you.
Now, there’s no income limit with a traditional IRA. But there is one with a Roth, based on your tax filing.
For example, married couples filing jointly can contribute up the max if their modified adjusted gross income is less than $198,000 (current as of 2021).
If their income is higher, they might qualify for reduced contributions. But they’re completely ineligible for a Roth IRA once they earn $208,000 a year or more (unless using the backdoor method). This involves contributing to a traditional IRA, and then rolling the funds into a Roth.
As of 2020 you can now make contributions to a traditional IRA beyond the previous age limit of 70 1/2, just like you can with a Roth. The difference, though, is that a traditional IRA requires minimum distributions beginning the year you turn 72, whereas Roth IRAs aren’t subject to minimum distributions.
Similar to a 401(k), withdrawing money from a traditional IRA before age 59 1/2 can have financial consequences, such as a 10% early withdrawal penalty and taxes (unless you have specialized circumstances).
However, you can withdraw Roth IRA contributions at anytime without penalty, although you might pay income tax and a 10% penalty if you withdraw earnings before age 59 1/2.