Saving for retirement can be super confusing. Even so, you need to save if you want to have a shot at retiring with a decent standard of living. Thankfully, the federal government wants to help you save for retirement. They even offer tax incentives to do so.
Ready to start thinking about retirement?
IRA (Individual Retirement Arrangement) and Roth IRA accounts give most people a tax-sheltered way to save for the biggest expense you’ll ever have to save for. Optimizing your future income may not seem like a big deal, but every penny counts.
But what exactly is an IRA account?
An IRA account is a tax-advantaged financial account typically held at a financial institution like a bank, brokerage firm or robo-advisor. Depending on where you open your IRA, you can invest the money you put in your IRA in a savings account, CDs, stocks, bonds, ETFs, mutual funds or other investment options.
The main difference between an IRA account and a regular account of the same version, such as a brokerage account, is the tax-advantage you receive.
Here’s what you need to know about IRAs and Roth IRAs. With this knowledge, you can determine which is better for you. That said, make sure to consult with a financial professional. Professionals can give you advice specific to your financial situation.
IRAs and Roth IRAs Have Some Things in Common
While IRAs and Roth IRAs offer different tax advantages and have different limitations, they do have some things in common. Both types of retirement accounts allow you to contribute up to $5,500 per year (2018). If you’re over age 50, you can contribute up to an additional $1,000 per year (2018).
It’s important to note you cannot contribute $5,500 to a Roth IRA and contribute an additional $5,500 to a traditional IRA.
But you could contribute $2,750 to a traditional IRA and $2,750 to a Roth IRA in the same year.
Traditional and Roth IRAs also have the same contribution deadline. You can contribute to an IRA up until the day your individual tax return is due for that calendar year (no extensions). Typically, this is April 15th but holidays may move the tax deadline in some years.
The Tax Advantages of a Traditional IRA
Traditional IRAs potentially give you the ability to deduct your contributions from your taxable income today. They also allow your earnings to grow tax-free.
But when you withdraw money from your traditional IRA in retirement, your withdrawals will be treated as ordinary income subject to income tax.
Can I Claim a Tax Deduction for a Traditional IRA?
Not everyone qualifies for the tax deduction. If neither you or your spouse has access to a workplace retirement plan, your IRA contributions will be fully tax deductible.
If you or your spouse have access to a workplace retirement plan, like a 401(k), you’ll only be able to claim the tax deduction if your income falls below certain limits. These limits vary based on your tax filing status.
You can still contribute to a traditional IRA if your income exceeds the limits.
You just won’t get the tax deduction.
If you’re married and are not covered by a retirement plan at work but your spouse is, you can contribute to a tax-deductible IRA if your modified adjusted gross income (MAGI) is $189,000 or less and you file a married filing jointly tax return.
The deduction phases out completely after you exceed the above limit by $10,000.
If you’re covered by a retirement plan at work, you can still contribute to a fully tax-deductible IRA as long as your MAGI is $63,000 or less for single or head of household filers or $101,000 or less for married filing jointly filers.
The deduction phases out over the next $10,000 of MAGI for single and head of household filers and over the next $20,000 of MAGI for married filing jointly filers.
In both cases, your MAGI must be less than $10,000 to claim a partial deduction if you file a married filing separately tax return. These filers cannot claim a deduction if their MAGI is $10,000 or more.
The Tax Advantages of a Roth IRA
Roth IRAs do not allow you to deduct your contributions from your taxable income today. Even so, your investments will grow tax-free. They key is you won’t have to pay income tax on withdrawals from a Roth IRA in retirement.
Roth IRAs also have income limitations. You must fall below these limitations to directly contribute to a Roth IRA account.
If you exceed these limits, you can get around the limit with what is called a backdoor Roth IRA. Essentially, you contribute to a traditional IRA. Then, you immediately recharacterize the contribution to a Roth IRA.
An additional benefit of a Roth IRA is the ability to withdraw contributions made to the account before you reach retirement age (59 ½) without paying taxes or penalties. If you want to withdraw earnings, you may have to pay taxes and penalties.
What taxes or penalties you pay depend on the use of the money and how long you’ve held the account.
Can I Contribute to a Roth IRA?
You can fully contribute to a Roth IRA if you file as single, head of household or married filing separately (as long as you didn’t live with your spouse at any time during the year) and your MAGI is less than $120,000.
Your contribution limit is reduced over the next $15,000 of MAGI until you can no longer contribute to a Roth IRA at a MAGI level of $135,000 or higher.
If you file married filing jointly, you can fully contribute to a Roth IRA as long as your MAGI is below $189,000. Your contribution limit decreases over the next $10,000 of MAGI until you cannot contribute to a Roth IRA at a MAGI level of $199,000 or above.
If you file married filing separately and lived with your spouse at any time during the year, you can contribute a reduced amount up to a MAGI of $9,999. Beginning at $10,000, you cannot contribute to a Roth IRA.
If your MAGI exceeds these limits, you could still contribute using the backdoor Roth IRA strategy.
When a Traditional IRA Is Better for You
A traditional IRA is the better option when you predict your future withdrawals will be taxed at a lower income tax rate than your current income tax rate.
For instance, if you’re in your peak earnings years, it’s very possible you could pay a lower income tax rate when you withdraw money from your traditional IRA in retirement.
Similarly, if you’re in a dual income household but plan to have an earner leave their job and be a stay at home spouse in the future, your current tax rate may be the highest it will be in your lifetime.
In this case, a traditional IRA may make the most sense as long as you can claim the tax deduction.
When a Roth IRA Is Better for You
A Roth IRA is the better option when you predict your future withdrawals would be taxed at a higher rate than your current income tax rate. For instance, if you’re just getting started in your careers, your future earnings will likely be much higher.
If your future earnings allow you to put enough money away to bump up your income in retirement, using a Roth IRA at the beginning of your career will let you lock in what could be the lowest tax rate you’ll pay in your life.
Since Roth IRAs allow you to withdraw your contributions tax and penalty free, these accounts offer more flexibility. Some people use Roth IRA contributions as a backup emergency fund. Others may use their Roth IRA as a source for the down payment on their first home.
Keep in mind, withdrawing earnings may require you to pay taxes or penalties.
If you plan on leaving money to your future children, it’s important to note Roth IRAs don’t have required minimum distributions (RMDs). Roth IRAs passed on to non-spouses will require minimum distributions, but the money will still be withdrawn income tax free as long as you held the account for more than five years.
Finally, if you’re maxing out your IRA each year, a Roth IRA allows you to shelter more income from future taxes. While both accounts have a $5,500 contribution limit for those under 50, you won’t have to pay future taxes on a $5,500 withdrawal from a Roth IRA.
That same $5,500 in a traditional IRA will be worth less in retirement due to the taxes you’ll have to pay. To get a similar benefit with a traditional IRA, you’d have to contribute the $5,500 in your IRA plus the amount of your anticipated tax savings from contributing to an IRA in a separate taxable account.
A Mix of Roth IRA and Traditional IRA Funds Is Best
Ultimately, you should consider a strategy where you have access to both traditional and Roth funds available to you when you retire. Then, you will have options and can withdraw from whichever account makes the most sense based on your needs.
For example, you could withdraw from the traditional IRA until you’re about to hit a higher tax rate.
Once you hit that higher rate, use tax-free Roth funds for the rest of your income needs that year.
The key to maximizing the tax benefits of these retirement accounts is contributing to a Roth IRA in your lower tax rate years and a traditional IRA in your higher tax rate years.
No One Has a Crystal Ball
Unfortunately, no one has a crystal ball that can predict the future. You don’t know if politicians will change the rules on how IRAs and Roth IRAs will work. You don’t know if income tax rates will be higher or lower 30 years down the road when you’re ready to retire.
All you can do is make an educated guess of what you think will happen and hope you’re right.
Lance Cothern is a WealthFit Contributor. He's a freelance writer and founder of the personal finance blog Money Manifesto. He also holds a Certified Public Accountant license in the Commonwealth of Virginia.