An individual retirement account, or IRA, can be a highly effective way to save and invest for retirement. The tax-deferred nature of these accounts can allow savers' money to grow and compound far more efficiently than in a standard taxable brokerage account. There are two main types of IRAs to choose from: traditional and Roth.
With that in mind, here's an in-depth look at the differences between the two main types of IRA, the qualifications for each one, and what you need to know about how these accounts work.
What is an IRA?
IRA stands for individual retirement account (or individual retirement arrangement). An IRA is a savings vehicle designed to help Americans save and invest for retirement in a tax-advantaged manner.
For most people (self-employed individuals have a few more options), there are two types of IRAs available -- traditional and Roth.
Both types of IRA have certain characteristics in common. Specifically, investments held in an IRA are allowed to grow and compound without any tax implications for as long as they remain in the account. For example, if you own a stock in your IRA and receive dividends, you won't have to pay dividend tax each year. If you own bonds in your IRA, you won't have to pay federal income tax on the interest you receive. And finally, if you sell investments in your IRA at a profit, you won't be liable for paying capital gains tax as long as you don't withdraw the money.
Traditional IRAs give you a tax break now
The main difference between traditional and Roth IRAs is the way they are treated by the IRS, so that's where we'll start.
As I mentioned, both types of IRA allow your investments to grow and compound without income taxes as long as the money remains in the account. The main difference is how contributions are treated.
With a traditional IRA, qualifying contributions are eligible for a current-year tax deduction. In other words, if you qualify for the traditional IRA tax deduction (we'll get into the qualifications later) and you contribute $2,000 to a traditional IRA for the 2018 tax year, you'll be able to exclude this amount of money from your taxable income.
Traditional IRA funds are not taxed until they are withdrawn from the account. Your eventual traditional IRA withdrawals, regardless of when or why they are taken, will be considered taxable income.
Roth IRAs give you a tax break later
On the other hand, Roth IRA contributions are never deductible in the year they're made. If you contribute to a Roth IRA for the 2018 tax year, that money will still be included in your taxable income.
Instead, the tax benefit of a Roth IRA comes later. Qualified withdrawals from a Roth IRA are 100% tax free. To get this tax-free treatment, your Roth IRA must have been open for five years or more, and you must meet a qualifying withdrawal condition, such as reaching a minimum age.
We'll get into the specifics of IRA withdrawals later, but the point is that Roth IRAs are designed to prepay your taxes now so you don't have to pay tax on your Roth IRA income in retirement.
Roth IRAs have some other key advantages
In addition to the tax treatment, Roth IRAs have a few other important benefits that are worth mentioning, all of which relate to the tax prepayment nature of these accounts.
First, you are free to withdraw your Roth IRA contributions at any time, and for any reason, without having to pay a 10% early withdrawal penalty to the IRS. You cannot withdraw any investment earnings without paying a penalty, but from the perspective of the IRS, you've already paid taxes on your contributions, so you can do with them as you'd like.
Additionally, there's no maximum age for contributing to a Roth IRA. As long as you have earned income (from a job or business you actively participate in), you can make Roth IRA contributions, provided you meet the income limitations. On the other hand, traditional IRA contributions are not permitted after the account owner turns 70 1/2 years old.
Finally, there are no minimum distribution requirements from a Roth IRA as you get older. Traditional IRA account owners are required to start taking distributions after reaching 70 1/2 years of age. The idea is that traditional IRAs are tax-deferred accounts, and the IRS wants to start getting some tax eventually. Since Roth IRA withdrawals can be tax free, there's no reason for the IRS to force account owners to take distributions.
IRA contribution limits
The IRS determines the IRA contribution limit each year. For the 2018 tax year, there are two different IRA contribution limits, depending on the age of the account owner.
- If you are under 50 in 2018, you can contribute as much as $5,500 to your IRA(s) for the 2018 tax year.
- If you are 50 or older in 2018, you can contribute as much as $6,500 to your IRA(s) for the 2018 tax year. The extra $1,000 is known as a "catch-up contribution."
Technically speaking, the limit is either of these amounts or your earned income for the year, whichever is less. In order to contribute to an IRA, you need to have income from a job or from a business you own and actively participate in. In other words, if your only earned income in 2018 is $2,000 from part-time employment, that's all that you're allowed to contribute to your IRA for the year, even if you meet all of the other requirements.
The timetable for IRA contributions is a little more flexible than the calendar year. Contributions for a specific tax year can be made any time between the first day of that calendar year and the regular tax deadline in the following April. This means that 2018 IRA contributions can be made anytime between January 1, 2018, and April 15, 2019.
It's also important to mention that the IRA contribution limits are per person, not per account. In other words, there's no reason you can't have more than one IRA, but your combined contributions to all of your IRAs cannot exceed your annual contribution limit.
Additionally, it's worth noting that there's no such thing as a joint IRA -- that's why they're called individual retirement accounts. If you and your spouse both want to save for retirement with IRAs, you'll need to open individual accounts for each of you.
However, there is such a thing as a spousal IRA. If one spouse meets all of the IRA eligibility requirements except that they don't have any earned income, the other spouse is allowed to contribute to an IRA on their behalf, as long as the working spouse's earned income justifies both IRA contributions.
Traditional IRA deduction income limits
To be clear, all Americans under the age of 70 1/2 can contribute to a traditional IRA. However, the ability to take the deduction for those contributions -- generally the primary reason to contribute to a traditional IRA -- is subject to income limitations for certain individuals.
These income restrictions depend primarily on whether the account owner or their spouse has access to a retirement plan at work. (Note: If you aren't sure, there's a box on the W-2 form that you receive each year that's labeled "retirement plan." If this box is checked, the traditional IRA deduction income limits apply to you, even if you don't participate in your employer's plan.)
Here's how the income restrictions work:
First, if you aren't eligible to participate in an employer-sponsored retirement plan and neither is your spouse (if married), it doesn't matter how much you earn. You can deduct your full traditional IRA contribution, regardless of your income, up to the annual contribution limit.
If you are eligible to participate in a retirement plan (such as a 401(k) or 403(b)) through your employer, your ability to take the traditional IRA deduction is income restricted. For 2018, here are the adjusted gross income (AGI) limitations by tax filing status:
Here's what this means. Let's say that you're single and have a 401(k) at work. If your AGI is under $63,000 for 2018, you can deduct your full traditional IRA contribution. If your AGI is greater than $63,000 but is less than $73,000, you can take a partial deduction for your contribution, which you can figure out on Worksheet 1-2 in IRA Publication 590a. And if your AGI is $73,000 or higher, you are ineligible for a traditional IRA deduction for the 2018 tax year.
The final category includes married individuals who are not eligible to participate in an employer's retirement plan, but their spouse is. In this case, the ability to deduct traditional IRA contributions is still income restricted, but for joint filers, the limit is significantly higher.
Roth IRA income limits
While the traditional IRA income restrictions only apply to the deduction, Roth IRAs have income limits that affect individuals' ability to contribute at all. Also, unlike the traditional IRA income limits, the ability to contribute to a Roth IRA doesn't depend on employer retirement plan eligibility. There's a single set of Roth IRA income limits that applies to everyone:
Here's how to interpret these limits. Let's say that you're married and file a joint tax return with your spouse. If your 2018 combined AGI is $189,000 or less, you can make a Roth IRA contribution up to your 2018 limit. If your combined AGI is more than $189,000 but is less than $199,000, you are eligible to make a partial contribution, which you can determine on Worksheet 2-2 in IRS Publication 590a. And finally, if your AGI for 2018 is $199,000 or greater, you aren't eligible to directly contribute to a Roth IRA for the 2018 tax year.
The "backdoor" Roth IRA
Notice that I used the word "directly" in that last sentence. This is because if your income exceeds the Roth IRA contribution income limit, you aren't able to deposit money in a Roth IRA for the current tax year. However, there is a perfectly legal way around this.
Known as the "backdoor" method of contributing to a Roth IRA, there's a rule that allows individuals to convert a traditional IRA to a Roth IRA regardless of their income. In other words, there's no reason you can't deposit money into a traditional IRA and immediately convert the account to a Roth IRA.
When can you withdraw your money?
Since IRAs are designed as retirement savings vehicles, you typically need to be at least 59 1/2 years old in order to withdraw money from your account without paying an early-withdrawal penalty. If you decide to withdraw from an IRA without meeting the age requirement or one of the exceptions I'll outline in the next section, the penalty for an early withdrawal is 10%.
Additionally, in order for a Roth IRA withdrawal to be tax-free, the account must have been open for at least five years.
Exceptions to the early-withdrawal penalty
There are a few exceptions to the IRA early-withdrawal penalty. Here's a rundown of the main ways you could withdraw money from your IRA before turning 59 1/2 years old without paying the 10% additional tax on early withdrawals:
- IRA withdrawals can be taken without penalty to pay for qualified higher education expenses.
- Up to $10,000 can be taken penalty free if used for a qualified first-time home purchase.
- IRA withdrawals are penalty free if taken to cover unreimbursed medical expenses in excess of 7.5% of AGI or to pay for health insurance premiums while you're unemployed.
- Distributions to qualified military reservists called to active duty can be penalty free.
- Withdrawals can be taken as a series of substantially equal payments. These must continue for at least five years or until the account owner reaches age 59 1/2, whichever comes later.
- If you become totally and permanently disabled, the IRA early-withdrawal penalty will not apply to you.
Can you borrow money from an IRA?
The short answer is no. While employer-sponsored retirement plans such as 401(k)s often allow participants to borrow money from their account in the form of loans, there is no such provision for IRAs. To be clear, there is no such thing as an IRA loan.
Having said that, there's a way that you might be able to borrow from your IRA on a short-term basis. The IRA rollover rule allows funds to be withdrawn as long as they're redeposited into a retirement account (the same account or a different one) within 60 days. In other words, if you need to borrow money from your IRA until the next time you get paid, it's possible to take out what you need and put it back later, as long as the process is finalized within 60 days.
What's best for you?
Looking at the traditional-versus-Roth debate purely from a tax perspective, a traditional IRA is appropriate for savers who are in a relatively high tax bracket right now. In other words, if the marginal tax rate you pay now is likely to be greater than the marginal tax rate you'll pay in retirement, the traditional IRA tax deduction is likely to be more beneficial than the tax-free withdrawal benefit of a Roth IRA.
Conversely, Roth IRAs are best for individuals who are in the lower tax brackets now. For instance, if you're in the 10% or 12% marginal tax bracket for 2018, it's tough to justify the assumption that your tax rate will be even lower in retirement. As a general rule, I often suggest a Roth IRA for Americans in the lowest two tax brackets and a traditional IRA for individuals whose marginal tax bracket is higher (provided they qualify based on income and employer-sponsored plan eligibility).
As a personal example, I contributed to a Roth IRA when I was just getting started in my career and my income was taxed at a low rate. As my career progressed and my income increased, I shifted my focus to the tax-deferred nature of the traditional IRA.
Having said all that, the other benefits of a Roth IRA can factor into your decision. For example, if you don't necessarily want your money tied up until you reach 59 1/2 years of age, you might be more comfortable with a Roth IRA regardless of your tax bracket. Or if you're nearing retirement age and don't want to be forced to withdraw from your account after reaching a certain age, that could also make a Roth IRA the more appealing choice.
The bottom line is that while the tax treatment is the primary difference between traditional and Roth IRAs and should certainly be a major factor in your decision, the other benefits of Roth IRAs as well as your personal preferences should also be taken into consideration.
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