Proper planning of retirement is crucial to ensure you can retire comfortably and with minimal worries.
One of the best ways to do this is by opening an individual retirement account (IRA), which is a savings account that allows people with earned income to put money in a long-term, tax-advantaged investment account that grows over time.
There are a few types of IRAs, but the two most common are traditional IRAs and Roth IRAs.
Though they share several similarities, they also have differences that can significantly affect how each account is taxed and by extension, the amount you’ll actually be able to get come retirement time.
Traditional IRA
A traditional IRA is funded with pre-taxed income, much like a 401(k). Any contributions made to a traditional IRA can be deducted from taxable income in the year the contribution is made.
Contributions to a traditional IRA are higher than they would be in the form of take-home income, since the amount going into the account is untaxed.
The full IRA contribution amount can be deducted from taxable income for those earning under $77,000 for single filers and $123,000 for married joint filers.
For those who earn between $123,000 to $143,000 for joint filers and $77,000 to $87,000 there is a phase-out schedule.
There is a maximum allowable contribution of $7,000 per year for people under the age of 50. Those aged 50 and older are allowed an extra $1000 ‘catch-up’ contribution each year, bringing the total allowable contribution to $8,000 a year.
The money in a traditional IRA account grows until the account holder reaches retirement age, which is currently 59½.
At that point, the account owner is able to withdraw funds and receive dividends, both of which are considered “distributions.” Distributions from a traditional IRA account are considered income in the year they are withdrawn, and are taxed accordingly for the fiscal year the withdrawal is made.
Early withdrawal from a traditional IRA before the retirement age of 59½ is possible, but for the most part, there is a fixed 10% penalty of the withdrawal amount.
There are some exceptions where the withdrawal penalty will be waived, including educational expenses, financing for a first-time homebuyer, or a medical emergency.
Related: New IRS Law Allows $1000 Tax-Free Emergency Loans From 401(k)s and 403(b)s
Traditional IRAs also have a “required minimum distribution” (RMD). Starting at age 72, the account holder of a traditional IRA must begin taking a distribution from their account, or incur an excise tax of 50% on the would-be required distribution amount.
Because a traditional IRA is funded with untaxed income, the government mandates withdrawals at a certain age to ensure there is a taxation event on the funds in the account.
Traditional IRAs may be a good option for those who anticipate their retirement income will fall in a lower tax bracket.
Roth IRAs
A Roth IRA differs from a traditional IRA in a few key ways.
Perhaps most importantly, contributions made to a Roth IRA are made with post-taxed income. This makes shoring up an IRA with funding more expensive upfront. It also means that contributions to a Roth IRA account will not lower your tax bill in the year the contribution is made.
But the advantage of a Roth IRA is that come retirement time, after the account has had time to grow with interest from investments, account owners are able to make tax-free withdrawals, as long as certain conditions are met.
For one, in order to make tax-free withdrawals from a Roth IRA, the Roth IRA account must have been open for at least five years.
But unlike traditional IRAs, Roth IRAs do not have a required minimum distribution (RMD). Withdrawals are not mandatory—the account can essentially sit and grow indefinitely, should the holder decide to bide their time.
Because the taxation event on the funds already occurred at the time contributions were made, the government has “no vested stake” in the timing of Roth IRA distributions.
Another key difference is that not everyone is qualified to open a Roth IRA. Eligibility is based on income limits.
In 2024, for single filers, the contribution limit starts to phase out if modified adjusted gross income (MAGI) is between $146,000–$161,000.
Those who earn above $161,000 income annually are ineligible, while married couples doing a joint filing have a phase-out range of $230,000 to $240,000. A phase-out means that the higher your income, the lower the amount allowed to be contributed to your Roth; those who pass the upper boundary are not allowed to contribute.
IRA Account Considerations
One way to think of the difference between a traditional IRS versus a Roth IRA is as a snowball.
A Roth IRA starts off as a smaller snowball but rolls into a bigger and bigger snowball over time. However big the snowball gets, it is fully owned by whoever made the initial snowball.
Meanwhile, for a traditional IRA, the starting snowball is larger. Over the same period of time, it grows even larger than the Roth IRA snowball. But when retirement comes, a big chunk of the larger snowball will be due in the form of taxes. Once that chuck is cut out, it may actually work out to be less than the Roth IRA’s snowball.
When considering the two types of accounts, working with a professional retirement planner can help you make the decision that will build the most financial security in retirement.
Picking the right account involves determining your expected expenses and Social Security income. It also requires estimating which tax bracket you’ll fall into at retirement.
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