When it comes to retirement savings, one of the best options available to those who don’t have a workplace retirement plan is an IRA. These savings vehicles allow for future retirees to save up to $6,000 per year in a tax-advantaged manner as of 2019. Those who have reached age 50 can add another $1,000 to their accounts each year.
Types of IRAs
There are two main types of IRAs. The first is the traditional IRA, and it allows individuals to save on a tax-deferred basis. Effectively, a traditional IRA allows account holders to cut their adjusted gross income by the amount of their savings. This will cut a retirement saver’s taxes in the year the money gets saved. The second is the Roth IRA, and this account allows people to save after-tax income while allowing for tax-free growth and withdrawals as long as certain conditions are met.
When Are Taxes Due?
The tax advantages of IRA accounts are their strongest characteristic. In a taxable account, savers would have to pay taxes on any dividends or capital gains earned within a given year. Within an IRA, those taxes are deferred in the case of a traditional IRA or nonexistent in the case of a Roth. Those who have a Roth IRA pay their tax bill up front, and the government will never tax the contributions or the withdrawals as long as the withdrawal of any gains comes after age 59.5.
On the other hand, those who save in a traditional IRA will have to pay taxes when they withdraw the money. The effective rate could be 0% as long as the taxpayer has enough deductions to avoid exceeding the standard deduction or any itemized deductions. Most people will not find themselves in this situation. The rate could theoretically go up to the top marginal rate the IRS charges at any given time. As of 2019, that rate is 37%, but a retiree would have to have an income of more than $500,000 to hit that rate.
With a Roth IRA, it’s possible to take out the contributions without penalty at any time as long as the account is at least five years old. This is not possible with a traditional account. Any withdrawal from a traditional IRA will be taxable because of the up-front tax deduction. The government wants the tax revenue at some point. Any withdrawals of contributions or growth from a traditional IRA would incur an early withdrawal penalty of 10% if the account holder is not yet 59.5 years old. Only the growth would see the early withdrawal penalty with a Roth.
Which Is Better?
Like many personal finance decisions, the answer to the question of which IRA is better depends upon a person’s individual situation. Those who have higher incomes can lose the tax benefit on a traditional IRA if they have a workplace retirement plan like a 401(k). The ability to contribute to a Roth IRA phases out if a worker makes $137,000 as of 2019. Couples can make up to $203,000 and still contribute to a Roth. Those who are married with children and have a relatively low income would likely do better with a Roth because they would pay little in taxes even before any IRA savings. Those with a higher income can take advantage of the tax-deferred benefit of the traditional IRA.
It’s also possible to contribute to a “backdoor” Roth account. Families with higher incomes could transfer money from a traditional IRA to a Roth in years they have a low adjusted gross income due to deductions from business losses or other reasons. This allows for the tax-deferred deduction up front and the benefits of tax-free withdrawals from a Roth while minimizing taxable income throughout the process.
Another consideration when it comes to IRAs are the required minimum distributions, commonly known as RMDs. There are no RMDs with a Roth IRA, which could leave the money to compound for decades after retirement. Those who invest in a traditional IRA will have to take out a growing percentage of their accounts each year after hitting 70.5 years of age. The percentage grows each year based upon expected mortality rates. Again, the government wants the tax revenue at some point. Regardless, of which account a person decides to use, deciding to save for retirement is an important step to take to ensure financial stability in old age.