The two most common retirement savings accounts available to all Americans are the Roth IRA and traditional IRA. Both accounts allow workers to contribute and invest money on a tax-deferred basis for retirement, but Roth IRA withdrawals are tax-free while traditional IRA contributions may qualify for a tax break.
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Similarities between the two types of IRA
There are a few similarities that apply to Roth and traditional IRAs. For example, the contribution limit to both IRA types is the same. In 2017, you can contribute a total of $5,500 to your IRA, with an additional $1,000 catch-up contribution allowed if you're 50 or older. It's also important to mention that this is a per person limit, not per account. If you have more than one IRA, your total contribution cannot exceed the limit.
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In addition, both accounts allow your investments to grow tax-deferred. This means that when one of your investments pays a dividend, you won't pay tax on your dividends at the end of the year. Also, when you sell an investment in an IRA at a profit, you won't pay capital gains tax.
Finally, the investment options are the same in both types of IRAs. In either a Roth or traditional IRA, you can invest in virtually and stock, bond, or fund you want, or you can keep some money in cash equivalents like CDs or money market assets.
Roth IRAs have some valuable benefits
Unlike most other retirement savings plans, your contributions to a Roth IRA won't get you a tax deduction. However, your eventual withdrawals once you retire will be 100% tax-free. A Roth IRA allows you to "lock in" your current tax rate in other words, you pay taxes on your income today, but not when you're retired.
In addition, there are a few other perks to investing in a Roth IRA:
- You are free to withdraw your original contributions (but not your investment gains) at any time, and for any reason. The way the IRS sees it, you've already paid tax on that part of your Roth IRA, so it's yours to do with as you please.
- Roth IRAs have no required minimum distributions as you get older. Since the IRS can't tax your Roth withdrawals, they really don't care how long your money stays in the account.
- Similarly, you are free to contribute to your Roth IRA no matter how old you are, as long as you have earned income.
The ability to contribute directly to a Roth IRA is limited by income. Specifically, if your 2017 income is above the maximums in this chart, you cannot contribute to a Roth IRA. If your income falls within the phase-out range, you can make a partial contribution.
Data Source: IRS. All figures are adjusted gross income (AGI).
It's also worth mentioning that there's a "backdoor" (LINK) method of contributing if your income is too high. Basically, you contribute to a traditional IRA and immediately convert the account to a Roth.
Traditional IRAs could get you a big tax deduction
The biggest reason to go with a traditional IRA is because contributions can be deductible on your current year tax return. In other words, if you contribute $5,000 to a traditional IRA in 2017 and you're in the 25% tax bracket, you could reduce your tax bill by $1,250.
So, if you're in a higher tax bracket now than you expect to be in retirement, a traditional IRA can be a smart idea.
Unfortunately, there are some downsides. Unlike Roth IRAs, you cannot withdraw your contributions early without paying a penalty. You'll also be required to start taking distributions after you turn 70 , and you cannot contribute to your account after reaching that age, even if you're still working.
While there is no income limit to contribute to a traditional IRA, there are income limits to qualify for the tax deduction if you or your spouse is eligible to participate in a retirement plan at work. For 2017, here's a table that can help you determine if you qualify for a traditional IRA deduction if you're covered by an employer's retirement plan. If you're above the higher number for your filing status, you're ineligible for the deduction, and if your income falls within the range, you may be eligible for a reduced deduction.
There are no income limits for the deduction if you're not covered by an employer's plan, unless your spouse is. In this case, if your combined AGI is less than $186,000, you can take a full IRA deduction. If you earn more than this, but less than $196,000, you are eligible for a partial deduction.
As you can see, there are several differences between the two IRA types. Here's a calculator that can help you compare the long-term tax advantages of both:
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
The Foolish bottom line
Obviously, if you make too much money to qualify for a traditional IRA deduction, it's probably not the best choice for you. Conversely, if an immediate tax deduction is a priority for you and you qualify for the traditional IRA deduction, the Roth IRA is probably not the way to go.
Assuming that you can qualify income-wise, neither type of IRA is necessarily a bad idea. However, each type can make better sense for certain people. The bottom line is that you should carefully weigh the advantages of each type of IRA in order to determine which makes the most sense for you.
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