Opening an IRA is a smart way to save for the future. If you're considering an IRA, you might be wondering whether it pays to stick to the traditional version or opt for a Roth. And while both types certainly have their benefits, there are a few drawbacks to traditional IRAs you ought to know about.
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1. You'll pay taxes in retirement
With a traditional IRA, the money you contribute will typically go in tax-free (though we'll talk more about that in a minute). Roth IRAs, by contrast, are funded with after-tax dollars, so there's no immediate tax break for contributing. The downside to getting an up-front tax break with a traditional IRA is that when the time comes to withdraw money in retirement, your distributions will be taxed at whatever your ordinary income rate is at that point.
Why is this a problem? First of all, it means you'll need to worry about taxes at a time when you're not working and are more financially vulnerable. Furthermore, while we know what tax rates are like today, we don't know what the future has in store. If tax rates go up across the board, you risk losing even more of your savings to the IRS.
2. You'll be subject to required minimum distributions
The money you put into a traditional IRA can't just sit there forever. Once you reach age 70 1/2, you're required to start taking distributions from your account. The amount you'll need to withdraw each year will depend on your IRA balance at the end of the previous year coupled with your life expectancy at the time. And if you fail to take your required minimum distribution, you'll be assessed a 50% penalty on the amount you neglect to withdraw. Ouch.
The problem with required minimum distributions is twofold. First, they automatically subject you to taxes that you'd otherwise avoid. Imagine, for example, that you're still working at age 70 1/2 and therefore don't need the money from your IRA. Also, because you're working and earning a decent salary, you're already paying your fair share of taxes to begin with. Since you'll have no choice but to start taking withdrawals on top of your salary, you're likely to get bumped into an even higher tax bracket. In addition, the more you withdraw from your IRA, the less growth you'll achieve on your balance.
This is why Roth IRAs offer a distinct advantage over traditional IRAs. Roth IRAs don't impose minimum required distributions, so if you don't need the money, you can let it sit and compound indefinitely.
3. You may not get that up-front tax deduction
If you don't have access to a retirement plan through your job and your spouse doesn't have access to one either, you can deduct your entire IRA contribution from your taxes as long as you aren't yet 70 1/2. Of course, your contribution will be subject to the annual limit, which is currently $5,500 if you're under 50 or $6,500 if you're 50 or older. But as long as you meet these criteria, you can benefit from a tax-free contribution.
However, if you do have the option to participate in an employer-sponsored 401(k) plan, you may not get an up-front tax break by contributing to a traditional IRA. Whether or not you'll get to take that deduction will depend on your tax filing status and how much you earn, as shown in the following table:
DATA SOURCE: IRS.
Now if you're not covered by a retirement plan at work but your spouse has access to one, you may qualify for a full or partial deduction for your IRA contribution if you file your taxes jointly. If your MAGI is $186,000 or less, you can take a full deduction. However, that deduction starts to phase out if you earn more than $186,000, and you can't take it at all if your MAGI is $196,000 or higher. If your tax status is married filing separately and your spouse is covered by a retirement plan at work, you can't take a deduction for contributing to an IRA if your MAGI is $10,000 or more.
While Roth IRAs offer more flexibility in certain regards than traditional IRAs, not everyone is eligible. There are income limits associated with Roth IRAs, and if you earn too much, you won't be allowed to contribute. That said, despite the aforementioned drawbacks, there are still benefits to putting money into a traditional IRA, so if you're looking to open one, you can visit our IRA Center to explore your options.
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