Saving for retirement: Traditional and Roth IRAs

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Should I use an IRA or Roth IRA to save for retirement?

Individual retirement accounts (IRAs) are tax-advantaged accounts that help you save for retirement. When we say that an IRA is tax-advantaged, we mean that it can offer greater tax benefits than regular investment accounts, which helps you achieve your retirement goals more quickly.

Two types of IRAs are most common: Roth IRAs and Traditional IRAs. They primarily differ in how and when taxes are applied to your contributions and investment gains. And by “applied to” your income and investment gains, we mean “taken out of” your income and gains. Simply put, with traditional IRAs, you pay taxes when you withdraw, and with Roth IRAs, you pay taxes before you contribute. Somehow, Uncle Sam always gets a cut. ?

Tax benefits are the big differentiator for IRAs

This difference in tax benefits (benefits now or benefits later) is the key reason you’d choose either a Roth or Traditional IRA. For instance, if you believe your taxes will be lower at retirement, it may make sense to use a traditional IRA to receive a tax deduction at a higher rate today, and pay taxes on investment gains at a lower rate later.

The opposite is true if your tax rate is already very low today and may rise in the future, making a Roth IRA more attractive. Additional considerations are whether you’ve already maxed out the tax benefits of a traditional IRA due to your participation in a 401(k) or whether you’re investing in riskier assets that could grow significantly, in which case, you’d likely prefer to receive those gains tax-free via a Roth IRA.

There are other important details, which we’ll discuss below.

Pre-tax contributions vs. after-tax contributions

Contributions to a traditional IRA are made with your pre-tax income (your gross income before taxes are taken out), and contributions to a Roth IRA are made with your after-tax income (your net income after taxes are taken out). In other words, a Roth IRA allows you to pay taxes on contributions today in exchange for tax-exempt gains later, while a traditional IRA helps you reduce your taxes today but requires you to pay taxes on your contributions and gains later.

Earned income is required to open a Traditional or Roth IRA

To open and contribute to a traditional IRA or Roth IRA, you must have earned income. Wages and salaries from an employer, as well as net earnings from self-employment and long-term disability benefits, all count as earned income. But interest, dividends, capital gains, unemployment benefits, and alimony do not count as earned income.

Contribution limits for Roth and Traditional IRAs

Nearly every retirement savings account puts a limit on how much money you can contribute to it each year. That figure is called your contribution limit. IRA contribution limits for 2018 are $5,500 for those under 50 and $6,500 for those 50 and older. But, if the amount of your total earned income was less than the $5,500 or $6,500 contribution limit, then the amount of your earned income becomes your contribution limit. In other words, you can’t contribute more money than you make.

Traditional IRA contributions and withdrawals

To open a traditional IRA, you must be under age 70 1/2. Contributions to traditional IRAs are made with pre-tax income, and they are tax-deductible based on your income and your eligibility for employer-sponsored retirement plan, such as a 401(k). To qualify for the full tax deduction with a traditional IRA, your adjusted gross income must be less than $63,000, or less than $101,000 if you are married and filing your taxes jointly.

Starting at age 59 ½, you can take withdrawals (distributions) from a traditional IRA without penalty, and the withdrawals will be subject to your current tax rate at the time of withdrawal. Note that you can make withdrawals prior to turning 59 ½ without penalties for qualified first-time home buyer’s expenses. But it’s widely recommended that you allow retirement savings to grow untouched and not dip into them early for other expenses.

While you can take withdrawals starting at age 59 ½, you’re not required to. However, you are required to start taking withdrawals by April 1 of the year after you turn 70 ½. These withdrawals are called required minimum distributions (RMDs). For example, if you turn 70 ½ on January 8, 2019, you must begin taking RMDs by April 1, 2020.

Roth IRA contributions and withdrawals

Contributions to Roth IRAs are made with after-tax income (income that you’ve already paid taxes on), and they are not tax-deductible.

When you make withdrawals from a Roth IRA, they are tax-exempt. Unlike traditional IRAs, Roth IRAs do not have mandatory withdrawals. Therefore, the age limit of 70 ½ doesn’t apply to Roth IRAs because there are no required distributions after age 70 ½. You can keep contributing as long as you have earned income.

Deciding what’s best for your retirement goals

Regularly contributing even a little bit to a retirement account like an IRA can help you build a solid nest egg for the future, thanks to the power of compound interest. Because the contribution limit on IRAs is lower than for 401(k) accounts, you should contribute to an employer plan first if you have access to one.

Whether a Roth IRA or IRA is better for you requires consideration of your current and future tax brackets, as well as your age. Because Roth IRAs don’t have mandatory withdrawals, they can be an ideal savings transfer vehicle (a way to pass money from one person or generation to the next), as there are no required minimum distributions and your beneficiaries (the people whom you designate to inherit your Roth IRA) will also not owe any income taxes on withdrawals. As always, it may be helpful to seek professional advice when deciding between these options.

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