Your Personal Guide To Traditional Vs. Roth IRAs

If you have begun to think about your retirement, specifically how you are going to fund your retirement, there is no doubt that you have had the Traditional vs. Roth IRA argument with yourself.  It seems that this is one of the most asked questions from individuals who are beginning to invest in their retirement.

There is no question that an individual retirement account, or IRA, can be highly effective in saving and investing for retirement.  The fact that these accounts are tax-deferred can allow your money to grow and compound in a much more efficient manner than it would in a taxable brokerage account.

Which type of IRA is right for you?  Let’s find out.

What’s an IRA?

As stated before, IRA stands for individual retirement account.  The basic premise of an IRA is to help Americans save and invest for retirement in a tax-advantaged manner.

For most people, two flavors of IRAs exist – traditional and Roth.

Similarities

You will find that there are certain similarities between the two types of accounts.  Specifically, investments held in an IRA are allowed to grow and compound without any tax implications for as long as they remain in the account.

This means that, for example, if you own stock in your IRA and receive dividends, you won’t need to pay dividend tax each year.  In the same vein, if you own bonds in your IRA, you won’t need to pay federal income tax on the interest you receive.  You also will not be liable for any capital gains tax for selling IRA investments as long as you don’t withdraw the money.

Differences

How are they handled by the IRS?

The main difference between a traditional IRA and Roth IRA is how they are handled by the IRS, which makes that a great starting point for our comparison.

As was mentioned before, both type of IRA allow your investments to compound without income taxes as long as no withdrawals are made.  The main difference between the traditional and Roth IRA is how contributions are handled.

Do you want a tax break now?

With a traditional IRA, qualifying contributions are eligible for a current-year tax deduction.  This means that if you qualify for the traditional IRA tax deduction and you contribute $2,000 to a traditional IRA for the current tax year, you’ll be able to exclude $2,000 from your taxable income.

Funds in a traditional IRA are not taxed until they are withdrawn from the account.  When that happens, they are considered taxable income.

Do you want a tax break later?

Unlike traditional IRAs, Roth IRAs contributions are never tax deductible for the current year.  If you make a contribution, it will be included in your current year’s taxable income.

What the Roth IRA does do, however, is make qualified withdrawals 100% tax free (as long as the account has been open for five years or more and you meet their qualifying withdrawal condition such as a minimum age).

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The short story is that a Roth IRA is designed to prepay your taxes now so you can avoid paying them when you retire.

But wait, there’s more!

The differences don’t stop with the contributions.  There are three more differences that should be noted.

First, you are able to withdraw your Roth IRA contributions at any time without having to pay that pesky 10% early withdrawal penalty to the IRS.  Note, this does not apply to any of your earnings, just your contributions since you have, essentially, already paid taxes on those.

Second, there is no maximum age limit for contributing to a Roth IRA.  As long as you are earning income from a job or business that you actively participate in and meet income limitations, you can make Roth IRA contributions.  Contributions to a traditional IRA are not permitted after age 70 ½.

Finally, Roth IRAs do not require the owner to take required minimum distributions (RMDs) as they get older.  Traditional IRA owners are required to begin taking RMDs after reaching the age of 70 ½.  The IRS has their reasons for this, of course.  Since traditional IRAs are tax-deferred, the IRS wants to get some money from these accounts eventually.

IRA Contribution Limits

The IRA contribution limit is determined by the IRS each year.  For the 2018 tax year, there are two different contribution limits depending on the age of the IRA owner.

  • Under 50 years of age: Can contribute up to $5,500 to your IRA(s) in the 2018 tax year.
  • 50 years of age or older: Can contribute as much as $6,500 to your IRA(s) for the 2018 tax year.

To be more specific, the maximum amount you can contribute to your IRA is the maximum of either your income for the year or the above amounts.  This means that, if you made $2,000 for the current year in income, you would only be able to contribute a maximum of $2,000 to your IRA for that year.

IRA contribution limits are per person, not per account.  This is very important to understand.  You are able to have more than one IRA, but your combined contributions to all of your IRAs cannot exceed your annual contribution limit.

The contribution timetable for IRAs is also slightly different than the calendar year.  Contributions for a specific tax year can be made any time between the first of the year and the regular tax deadline in the following April.

Traditional IRA Deduction Income Limits

Deductions on the contributions to traditional IRAs are subject to income limitations for certain individuals.

These restrictions deal primarily with whether the account owner or their spouse has access to a retirement plan at work.  Is the little box labeled “retirement plan” on your W-2 form checked?  These limits apply to you, even if you don’t participate in your employer’s retirement plan.

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How do the income restrictions work?

First, if you aren’t eligible to participate in an employer-sponsored retirement plan and neither is your spouse, you can deduct your full traditional IRA contribution, regardless of your income, up to the annual contribution limit.

If you are eligible to participate in an employer-sponsored retirement plan such as a 401(k) or 403(b), your ability to take the traditional IRA deduction is restricted by your income.  Below are the 2018 adjusted gross income (AGI) limitations by tax filing status provided by the IRS.

Tax Filing Status 2018 Traditional IRA Full-Deduction AGI Limit Phase-Out Limit
Single or head of household $63,000 $73,000
Married filing jointly $101,000 $121,000
Married filing separately $0 $10,000

 

To put this simply, if you are single, have a 401(k) at work, and your AGI is under $63,000 for 2018, you can deduct your full traditional IRA contribution.  If your AGI is between $63,000 and $73,000, you can take a partial deduction.  You can figure that deduction out by looking at Worksheet 1-2 in IRS Publication 590a.  If your AGI is $73,000 or greater, your ineligible for a traditional IRA deduction for the 2018 tax year.

When it comes to married individuals who are not eligible to participate in their employer’s retirement plan, but their spouse is, their ability to deduct traditional IRA contributions is still restricted by income, but the limit for joint filers is much higher.

Tax Filing Status 2018 Traditional IRA Full-Deduction AGI Limit Phase-Out Limit
Married filing jointly $189,000 $199,000
Married filing separately $0 $10,000

 

ROTH IRA Income Limits

In contrast to the traditional IRA income restrictions which only apply to the deduction, Roth IRAs has limits that apply to an individual’s ability to contribute to the IRA at all.  The Roth IRA is also not dependent on employer retirement plan eligibility.  There is simply one set of income limits that everyone abides by.

Tax Filing Status 2018 Roth IRA Full-Contribution AGI Limit Phase-Out Limit
Single or head of household $120,000 $135,000
Married filing jointly $189,000 $199,000
Married filing separately $0 $10,000

 

Basically, if you are single, and your 2018 AGI is $120,000 or less, you can make a Roth IRA contribution up to your 2018 limit.  If your AGI is between $120,000 and $135,000, you can take a partial contribution.  You can determine that contribution by looking at Worksheet 2-2 in IRS Publication 590a.  If your AGI for 2018 is $135,000 or greater, you aren’t eligible to directly contribute to a Roth IRA in the 2018 tax year.

Did you see the phrase “directly contribute” in the last paragraph?  If your income exceeds the Roth IRA contribution income limit, you cannot deposit money into a Roth IRA for the current tax year.  But let me introduce you to the…….

Backdoor Roth IRA

The backdoor Roth IRA got its name because it is, essentially, a backdoor method of contributing to a Roth IRA.  There is a rule that allows you to convert a traditional IRA to a Roth IRS regardless of your income.  What does this mean for you?  There is no reason that you can’t deposit money into a traditional IRA and immediately convert it into a Roth IRA.

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Withdrawing Your Money

IRAs are obviously retirement savings tools.  The whole reason you opened them is to fund your retirement.  For a typical IRA, you need to be at 59 ½ years of age in order to withdraw money from your account without dealing with nasty early-withdrawal penalties of 10%.  Also, to keep the withdrawal tax-free, the account must have been open for at least five years.

There are exceptions.

As with most rules in life, there are a few exceptions.  Here are some ways it is possible to withdraw money from your IRA before turning 59 ½ without shelling out an additional 10% in penalties.

  • You can withdraw up to $10,000 if it is used for a qualified first-time home purchase.
  • You can withdraw money from an IRA with no penalty if it is for qualified higher education expenses.
  • If the distributions are to qualified military reservists called to active duty.
  • If you happen to become totally and permanently disabled, you are able to withdraw from an IRA with no penalties.
  • There are no early withdrawal penalties if the money is used to cover unreimbursed medical expenses in excess of 7.5% of your AGI or to pay for health insurance premiums while you are unemployed.

 

Which Type of IRA is Better For You?

When looking at which type of IRA to open for your retirement, you need to look at your situation and your future needs.

Looking at it from a tax perspective, a traditional IRA is better suited for individuals in a relatively high tax bracket right now, but will be in a lower tax bracket in retirement.  On the flipside of that coin, if you are currently in a lower tax bracket, look at a Roth IRA.  It is unlikely that you will be in a higher tax bracket when you enter retirement.

Other factors include whether or not you will want any of the money before you are 59 ½ years of age.  If you will, you may want to go with a Roth IRA regardless of your tax bracket.  Also, if you do not want to be forced to make withdrawals from your account after reaching a certain age, you may want to consider a Roth IRA.

Nobody can make the final decision for you, we can only give you the facts and let you make the decision between a traditional and Roth IRA.  The main differences are the tax implications.

I hope this guide has provided you with more information than you had before and you are able to make an informed decision when the time comes.

MiddleAgeMoneyMan.com

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