Traditional individual retirement accounts allow individuals to direct pretax income toward investments that can grow tax-deferred; The IRS assess no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute 100 % of any earned compensation up to a specified maximum dollar amount. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors.
Simplifying “Traditional IRA”
Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles per the account holder’s instruction and based on the offerings available.
The IRS restricts amount that one may add to a traditional IRA each year depending on age. The contribution limit for the 2018 tax year is $5,500 for taxpayers under 50 years of age. For people age of 50 and above, higher annual contribution limits apply, allowing a contribution of up to $6,500 during the 2018 tax year. In the year you reach age 70½ you are no longer eligible to contribute to a traditional IRA.
If You Also Have a 401(k) or Other Employer Plan
When you have both a traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of your traditional IRA contributions you can deduct from your taxes. For example, in 2018, if a taxpayer participated in an employer-sponsored program, such as a 401(k) or pension program, the taxpayer would only be eligible to take the full deduction on a traditional IRA if his or her modified adjusted gross income was $63,000 or less if filing as an individual or $101,000 or less if married filing jointly.
With modified AGIs of $73,000 for singles and $121,000 for married couples, the IRS allows no deductions. In between, there’s a partial deduction. If you are above the limits, you can still contribute post-tax income to a traditional IRA and take advantage of its tax-free growth, but investigate other options, too.
Traditional IRA Distributions
When receiving distributions from a traditional IRA, the IRS treats the money as ordinary income and subjects it to income tax. Account holders can take distributions as early as age 59½. Starting after age 70½, account holders must take required minimum distributions from their traditional IRAs.
Funds removed before full retirement eligibility incur a 10% penalty (of the amount withdrawn) and taxes, at standard income tax rates. There are exceptions to these penalties for certain situations. These include:
- You plan to use the distribution towards the purchase or rebuilding of a first home for yourself or a qualified family member (limited to $10,000 per lifetime).
- You become disabled before the distribution occurs.
- Your beneficiary receives the assets after your death.
- You use the assets for medical expenses for which you were not reimbursed.*
- Your distribution is part of a SEPP program.
- You use the assets for higher-education expenses.*
- You use the assets to pay for medical insurance after you lose your job.*
- The assets are distributed as a result of an IRS levy.
- The amount distributed is a return on non-deductible contributions.
Other variants of the IRA include the Roth IRA, SIMPLE IRA and SEP IRA. Two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. These individual accounts can be created through a broker. You can check out some of the best options. Unlike a traditional IRA, a Roth IRA does not feature upfront tax-deductible contribution benefits. However, unlike a traditional IRA, the IRS does not consider distributions of funds contributed to – and generated from – a Roth IRA as taxable income and there are no RMDs during the account holder’s lifetime.
SIMPLE IRA’s and SEP IRA’s are benefits instituted by an employer and individuals cannot open them. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.
Comparing Roth and Traditional IRA’s
Trying to decide between a Traditional IRA or a Roth IRA? The type of individual retirement account (IRA) you choose can significantly affect your and your family’s long-term savings. So it’s worth understanding the differences between Traditional IRA’s and Roth IRA’s in order to select the best one for you.
Here are the key considerations:
1) Income Limits
It is a known fact that anyone with earned income who is younger than 70½ can contribute to a Traditional IRA. Whether the contribution is tax deductible depends on your income and whether you or your spouse (if you’re married) are covered by a retirement plan through your job, such as a 401(k).
Roth IRAs don’t have age restrictions, but they do have income-eligibility restrictions: In 2019, single tax filers, for instance, must have a modified adjusted gross income (MAGA) of less than $137,000 to contribute to a Roth IRA. (Contribution limits are phased out starting with a modified AGI of $122,000—per IRS guidelines.) Married couples filing jointly must have modified AGI’s of less than $203,000 in order to contribute to a Roth; contribution limits are phased out starting at $193,000. (For 2018, single tax filer needed a MAGA of less than $135,000, with the phase out starting at $120,000. For married couples filing jointly it was less than $199,000, with the phase out starting at $189,000.) The IRS has lots of information on the details.
2) Tax Incentives
Both Traditional and Roth IRA’s provide generous tax breaks. But it’s a matter of timing when you get to claim them. Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution; withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free.
With Traditional IRA’s, you avoid taxes when you put the money in. “With a Roth IRA, in retirement you won’t have to pay any taxes upon withdrawals of funds,” says Levi Sanchez, CFP®, cofounder of Millennial Wealth, Seattle, Wash.
“Since Roth IRA contributions are made on an after-tax basis, it is nice to take advantage of the time value of money and tax-free growth, especially if you are in a lower tax bracket today,” says Marguerita Cheng, CFP®, CRPC®, RICP, CDFA , CEO, Blue Ocean Global Wealth, Gaithersburg, Md. Of course, with both types of IRA’s, you pay no taxes whatsoever on all of the growth of your contributed funds, as long as they remain in the account.
3) Withdrawal Rules
One major difference between Traditional IRA’s and Roth IRA’s is when the savings must be withdrawn. Traditional IRA’s require you to start taking required minimum distributions (RMD’s)—mandatory, taxable withdrawals of a certain percentage of your funds—at age 70½, whether you need the money at that point or not. Roth IRA’s, on the other hand, don’t require any withdrawals during the owner’s lifetime. If you have enough other income, you can let your Roth IRAs continue to grow tax-free throughout your lifetime, making them ideal wealth-transfer vehicles.
The same applies to your heirs. Beneficiaries of Roth IRA’s don’t owe income tax on withdrawals and can stretch out distributions over many years. However, beneficiaries may still owe estate taxes. Both Traditional and Roth IRA’s allow owners to begin taking penalty-free, “qualified” distributions at age 59½. However, Roth IRA’s require that the first contribution be made at least five years before the first withdrawal, in order to avoid incurring a tax payment. If you meet that benchmark (and you only have to meet it once), you will have only paid taxes on what went into the account, not the sum you eventually take out.
4) Extra Benefits & Considerations
It’s also worth factoring in some of the specific rules and benefits of Traditional and Roth IRA’s. Here’s a breakdown:
- Contributions to Traditional IRA’s generally lower your taxable income in the contribution year. That lowers your adjusted gross income, helping you qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction. (Note that if you or your spouse has an employer retirement plan, your ability to deduct contributions may be reduced or eliminated.)
- If you are under 59½, you can withdraw up to $10,000 from your account without the normal 10% early-withdrawal penalty to pay for qualified first-time home-buyer expenses and for qualified higher education expenses. Hardships such as disability and certain levels of unreimbursed medical expenses may also be exempt from the penalty, However, you’ll still pay taxes on the distribution.
- Roth contributions (but not earnings) can be withdrawn penalty- and tax-free at any time, even before age 59½.
- If you are under 59½, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time home-buyer expenses, provided at least five tax years have passed since your initial contribution.
- Roth IRA’s can be invested in virtually anything you want: index funds, lifecycle funds, individual stocks, or manyalternative investments.
5) Future Tax Rates
Deciding between a Traditional and a Roth IRA depends, basically, on how you think your income—and by extension, your income tax bracket—will compare to your current situation. In effect, you’re trying to determine whether the tax rate you pay on your Roth IRA contributions today will be greater or smaller than the rate you’ll be paying on distributions from your Traditional IRA after you’ve retired (or have to start making them, at age 70½).
Of course, it’s hard to predict what federal and state tax rates will be 10, 20 or 40 years from now. Given today’s historically low federal tax rates and the large U.S. deficit, many economists believe federal income tax rates will rise in the future—meaning Roth IRAs may be the better long-term choice. But of course, no one knows.
“I often mention to clients who can contribute to both pre-tax and after-tax accounts that it’s great to have options to decide which tax pot to pull from in retirement based upon the specific tax year and situation that arises,” says Martin A. Federici, Jr., AAMS®, CEO of MF Advisers, Inc., Dallas, Pa. “Everyone knows that tax scenarios can change from year to year (sometimes for the good, sometimes not-so-good), and it’s better to be prepared by having flexibility at your fingertips.”
Still, you can ask yourself some basic questions about your personal situation: Which federal tax bracket are you in today? Do you expect to be in a higher or lower one after you retire? Will your annual income increase or decrease? Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about it. You’ll be collecting (and owing taxes on) Social Security payments. You might opt to do some consulting or freelance work, on which you’ll have to pay self-employment tax. And once the kids are grown and you stop adding to the retirement nest egg, you lose some valuable tax deductions and tax credits. All this could leave you with higher taxable income, even after you stop working full-time.
Tax Deductions Vs. Tax Credits
A quick primer on tax deductions and tax credits:
A tax deduction is an item the government lets you write off of your taxes to lower your total taxable income. Deductions usually only apply if you itemize them, rather than taking the standard deduction (which is now $12,000 for single taxpayers and $24,000 for married taxpayers filing jointly, thanks to the Tax Cuts and Jobs Act passed at the end of 2017). Itemizing deductions is beneficial only if the total amount surpasses the sum for the relevant standard deduction you qualify for. Deductions basically get you a discount on the tax you pay. You don’t take a dollar off of taxes for every dollar spent; instead, every dollar that is deducted from your taxable income lowers the amount of income you will be taxed on. If you are in the 22% tax bracket, for example, every dollar you deduct gets a 22-cent tax break.
In contrast, a tax credit is a direct reduction of the amount of tax you owe. Common credits have been issued for spending money on green home improvements or for going back to school. No matter which credits you use, you are slashing your tax bill to the federal government: If you have $2,000 in tax credits, your taxes drop by $2,000. You can take credits whether you take a standard deduction or itemize deductions.
Tax credits are usually more elusive and not as easy to claim as tax deductions—but they are much better, because they always reduce your taxes. If you have the opportunity to take a $5,000 tax credit or a $5,000 tax deduction, the credit is the better deal. Say you have a tax bill of $10,000. The deduction would lower your taxable income by $5,000; so, if you were in the 22% tax bracket, your taxes would be reduced by $1,100 to $8,900. A credit would directly lower the tax due to $5,000, and that’s regardless of your bracket.
So Which is Better for Me, a Roth or Traditional IRA?
Start by looking at your income. There are income limits for Roth IRA’s, so if your income is above those limits, then it’s a no-brainer: a traditional IRA is the only one for you.
Let’s say you’re eligible for both a Roth and a Traditional IRA. Generally, you’re better off in a traditional if you expect to be in a lower tax bracket when you retire. By deducting your contributions now, you lower your current tax bill. When you retire and start withdrawing money, you’ll be in a lower tax bracket, thereby giving less money overall to the tax man.
If you expect to be in the same or higher tax bracket when you retire, you may instead want to consider contributing to a Roth IRA, which allows you to get your tax bill settled now rather than later.
But it can be difficult, if not impossible; to guess what tax bracket you will be in later in life, particularly if you’ve got a long way to go until you retire. So if you’re not sure, another rule of thumb is to keep your retirement savings tax diversified, meaning you have accounts that will be both taxable and tax-free when you cash out in retirement. For example, if you already have a tax-deferred 401(k) plan through your employer, you might want to invest in a Roth IRA if you are eligible.
The Roth also offers more flexibility: You can withdraw your contributions (but not the earnings) without incurring a penalty so you have more access to your money. So if you’ve got a long way to go before retirement, and you’re concerned about locking away your money for too long and want to be able to get at it if you need it, a Roth IRA might be the way to go.