Retirement planning is a long journey. Assuming you start saving for your retirement in your 20s or 30s, it can still take considerable time for you to accumulate a sufficient corpus. To ensure a comfortable retirement, you must invest in instruments that offer you good returns, tax savings, flexibility, and growth against inflation. When it comes to retirement planning, employer-sponsored retirement plans are usually the first instrument that most people use. If your employer offers such a plan, you are headed in the right direction and can get a good jump start in your investment journey. However, not all jobs offer workplace retirement plans. In addition to this, even with an employer-sponsored plan like the 401(k) account, you may still want to invest more on the side for enhanced financial protection.
In such a case, an Individual Retirement Account (IRA) can be an excellent option. An IRA is a tax-advantaged retirement account that can be used for long-term savings. There are different types of IRA options that you can choose based on your requirements and tax concerns. Read on further to understand the different types of IRAs, how they work, and what the difference is between a Roth and traditional IRA. You may also consider consulting a professional financial advisor to learn more about the most suitable retirement plan for your needs.
How does an IRA work?
An IRA is a retirement savings account that can be set up at a financial institution, such as a bank, a credit union, or a broker. The Internal Revenue Services (IRS) sets the annual contribution limits for IRAs every year. You can contribute up to the prescribed limits set for that particular year. The annual limit is higher for people aged 50 or over. For instance, for the year 2021, you can contribute up to $6,000 per annum to your IRA. People aged 50 and above are also allowed to contribute a catch up contribution of $1000, bringing the total to $7,000.
An IRA can offer you tax deferred or tax free growth depending on the type of IRA you choose. Traditional and Roth IRA tax benefits can help in different ways, based on your present and future tax situation. To understand this better, you must know the difference between a Roth IRA and traditional IRA.
What is the difference between Roth and traditional IRA?
The main points of difference between Roth IRA and traditional IRA are:
- Taxability of traditional and Roth IRA
- Income limits of traditional and Roth IRA
Both traditional and Roth IRAs offer tax benefits that can help you get a tax break and lower your tax output. However, the only difference lies in when you receive this tax break. In the case of a traditional IRA, the contributions qualify for tax deductions when you file your state and federal tax returns. This means that you get an immediate tax break in the present and get to save money for your current needs. However, the money that you withdraw from your traditional IRA in retirement will be taxed. Your traditional IRA distributions will be added to your taxable income for the year and taxed according to the tax slab you will fall into in the future and the prevailing tax rates at that time.
In the case of a Roth IRA, you do not get an immediate tax break. There are no tax deductions on your taxable income for any funds that you contribute to your Roth IRA. However, you get to reap Roth IRA tax benefits on your distributions in retirement. Your withdrawals are not added to your taxable income, and you pay no tax on them.
Income limits refer to the income bracket of the investor investing in an IRA. In the case of a traditional IRA, there is no maximum income limit. Anyone with an earned income can contribute to a traditional IRA. However, there are certain income limitations if you or your spouse is also contributing to a workplace retirement plan. In such a case, the tax deductions may be reduced or phased out based on your filing status and income. As of 2021, here are the prescribed limits set by the IRS:
|Filing status||Income bracket|
|Single taxpayers with a workplace retirement plan||$66,000 to $76,000|
Married couples filing jointly: Spouse contributing to the IRA is covered by a workplace retirement plan.
$105,000 to $125,000
Married couples filing jointly: Taxpayer married to someone who is contributing to a workplace retirement plan.
$198,000 to $208,000
Married couples filing a separate return: Taxpayers covered by a workplace retirement plan.
$0 to $10,000
Roth IRAs, on the other hand, have very strict income limits for contributions. As of 2021, these are:
- You can contribute to a Roth IRA as a single taxpayer with a modified adjusted gross income (MAGI) of $140,000 or less.
- You can contribute to a Roth IRA as married taxpayers filing jointly, earning a joint MAGI of less than $208,000.
There are no age limits to contribute to any of the two retirement accounts.
Another difference between Roth IRA and traditional IRA lies in the distributions. Traditional IRAs have mandatory Required Minimum Distributions or RMDs. As per the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act), if you were 70.5 years of age in 2019, you had to take your first RMD by April 1, 2020. However, if you turn 70.5 in 2020 or later, you need to take your first RMD by April 1 of the year after you turn 72. If you fail to withdraw your RMDs at the right time, you will have to pay a penalty of 50% of the total RMD amount that you missed. The value of each RMD can be calculated as per the life expectancy factor published by the IRS. This can be found on the official IRS website. You can also consult a financial advisor to calculate the value of your RMDs. Further, you can withdraw more than the RMD value as per the life expectancy factor. However, it cannot be lower than the limit. In the case of multiple IRAs, you need to calculate the RMD separately for each IRA that you own. There are no mandatory RMDs for a Roth IRA. You can withdraw the funds whenever you like. You can also let the funds remain in the account and not withdraw them during your life if you wish. In such a case, your accumulated funds will be transferred to your next of kin through your estate plan.
An important point to note here is that while there may be a difference between Roth IRA and traditional IRA in terms of RMDs, other withdrawal rules remain more or less the same for both accounts. Additionally,you can withdraw your earnings only after the age of 59.5 in the case of both traditional and Roth IRAs. If you withdraw your earnings before the age of 59.5, you may have to pay a penalty of 10%. Moreover, to take out penalty free withdrawals from a Roth IRA, you also have to contribute to the account for at least 5 years.
However, there are certain exceptions. For instance, in the case of a Roth IRA, you can withdraw up to $10,000 of your earnings after 5 years without incurring any penalties if you are a first time home buyer. You can also withdraw your earnings without paying the penalty to cover qualified education expenses. Other reasons for a withdrawal will attract a penalty. However, this penalty only applies to the investment gains and not to your contributions. You can withdraw your contributions anytime without incurring a penalty.
In the case of a traditional IRA, you can take out penalty free withdrawals before the age of 59.5 only if you are a first time homebuyer or need to cover qualified education expenses. If not, you will have to pay a 10% penalty. This penalty is imposed regardless of whether you withdraw your contributions or investment gains.
Traditional IRAs vs Roth IRAs: which one should you choose?
The suitability of each account would depend on what you are looking for. Both these retirement accounts can offer unique benefits and, at the same time, pose certain limitations. Hence, the final call can only be taken after a careful assessment of your needs and future goals.
Investing in a traditional IRA can be beneficial in the following situations:
- If you think you are in a higher tax bracket right now than you would be in retirement, you can consider investing in a traditional IRA. Your money will grow tax deferred, and you will pay tax in retirement when you will be in a lower tax bracket. This way, you will end up saving more money in the long run.
- As of 2021, a single taxpayer can contribute to a Roth IRA with a modified adjusted gross income (MAGI) of $140,000 or less. Likewise, married taxpayers filing jointly can contribute to a Roth IRA with a joint MAGI of less than $208,000. If you do not meet the income eligibility criteria to invest in a Roth IRA, you can go ahead and invest in a traditional IRA. This will help you save more for retirement and also offer tax benefits.
Investing in a Roth IRA can be beneficial in the following situations:
- If you think you will be in a higher tax bracket after retirement than right now, you can invest in a Roth IRA. This way, you will pay tax on your contributions now. Your money will grow tax free, and you will not have to pay any taxes on your withdrawals in retirement.
- If you do not want to take mandatory RMDs according to the IRS rules, a Roth IRA can be a better option. With a Roth IRA, the decision to withdraw your money is entirely yours. You can take distributions or not touch your money for the rest of your life – the choice is completely yours.
- A Roth IRA can also be a better option if you want more flexibility in withdrawals. It allows you to take your contributions without paying any penalties. Although the earnings are penalized, you can still access your contributions in times of financial emergencies.
- If you already have a traditional 401(k) retirement account, you may consider investing in a Roth IRA. A traditional IRA offers similar tax benefits as a traditional 401(k) account. So, selecting a Roth account can help you diversify your investment portfolio better.
It may seem like Roth IRA offers more benefits than a traditional IRA, but its relevance in an investment portfolio can still vary from one investor to another. If you are looking for an immediate tax break, a traditional IRA can be your go to option. Despite the restrictions and limitations in withdrawals, your immediate tax concern will be solved, and you will be able to focus on your other goals better. However, if you are not concerned about your present tax liabilities as much and would rather focus on securing your future, a Roth IRA may be a better alternative. It offers increased flexibility and ease in retirement, along with lowering your tax liability.
Regardless of what you choose, make sure that you understand the pros and cons of both the traditional IRA and Roth IRA present. Knowing the difference between Roth IRA and traditional IRA and the applicable rules can help you make an informed decision. Keep in mind that since retirement accounts are long-term investments, it can always benefit you to consult a professional before you finalize your selection. Talking to a financial expert can help you in picking an instrument that is most suited to your requirements.
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