Saving for retirement is a major financial goal for anyone hoping to hop off the work train one day—and a traditional individual retirement account (IRA) is one good tool you can use to accomplish it.
How does a traditional IRA work?
Anyone can open a traditional IRA through their bank, broker or robo-advisor of choice. (Acorns offers these in addition to a regular brokerage account.) Then, you can contribute up to $6,000 in 2020, or up to $7,000, if you’re age 50 or older. As your investment grows, you get to enjoy one big benefit: You don’t have to pay annual taxes on earnings.
Once you start taking money out of the account in retirement, you will have to deal with the tax bill. But in the meantime, your contributions may be tax deductible, meaning you can lower your taxable income and ultimately your current tax bill by the amount you contribute. Whether you can fully take advantage of that tax break depends on your income and whether you or your spouse has access to a 401(k) or other employer-sponsored retirement account.
If you have a retirement plan through work, and you’re married and filing jointly, you can only take the full tax deduction if your modified adjusted gross income (MAGI) is $104,000 or less in 2020. And if your MAGI is $124,000 or more, you cannot deduct any of your contribution. If your spouse has a retirement plan through work, you can take the full deduction if your MAGI is $196,000 or less, and it phases out entirely when your MAGI hits $206,000 or more. If you’re a single filer who's also covered by a retirement plan at work, the amount you can deduct begins to phase out when your MAGI goes above $65,000 and is eliminated at $75,000.
How long do I have to wait to take the money out in retirement?
Uncle Sam has put some age restrictions in place to ensure you eventually pay taxes on this money. Once you reach the year you turn 72, you must start taking required minimum distributions (or RMDs) from your traditional IRA, though you can continue to make contributions. (Roth IRAs, on the other hand, have no such RMDs, but you must meet certain income requirements to be eligible for this type of IRA.)
Hold on. What are RMDs?
They’re the annual withdrawals that the IRS forces you to take from your tax-deferred retirement accounts, including traditional IRAs and 401(k)s, limiting how long you can defer that tax bill.
The amount you need to take out each year is determined by your account balance at the end of the previous year and which birthday you’re celebrating that year. You can use the IRS RMD Worksheet or any number of online RMD calculators to figure out exactly how much you’ll need to withdraw. And it’s important to get it right: If you take out too little, or if you miss an RMD deadline, you may have to pay a penalty of 50 percent of whatever you owe, plus taxes.
Does that mean Roth IRAs are better since they don’t force you to take RMDs?
Maybe? Having no RMDs is certainly an attractive benefit of Roth IRAs. Without them, you can pretty much let the money in your Roth grow forever, and then leave the entire account to your loved ones, if you want.
But that’s not all you have to consider when comparing the two types of retirement accounts. The major difference between traditional and Roth IRAs is in how they’re taxed: While traditional IRAs are taxed on the back end when money is withdrawn, Roth IRAs are taxed on the front end. So with a Roth, you contribute money that’s already been taxed, but withdrawals—including earnings—come out tax-free in retirement, as long as you’ve had the account at least five years.
(Btw, 401(k)s also come in traditional and Roth flavors, each with the same respective tax rules as their IRA counterparts.)
So which account is a better deal?
It depends. Some people think Roths are the way to go because who knows what’s going to happen with taxes? With a Roth, your tax bill is settled from the moment of contribution, and you no longer have to worry about which way tax rates are headed. With a traditional IRA, you risk facing higher taxes at distribution than you would’ve had to pay when you first contributed. In that case, a Roth would definitely have saved you money.
Plus, assuming you don’t need to tap your retirement savings early (fingers crossed!), your final account balance before you start withdrawing should far exceed the amount you contribute. And it makes sense that you’d rather pay taxes on the smaller sum. For example, if you save $6,000 a year for 30 years, your total contribution adds up to $180,000. But given, say, an average 6 percent annual return, your account ends up with more than double that amount. With the Roth option, you’d be paying taxes on the $180,000 that you contributed rather than the much bigger final total.
A Roth can also be a better deal if you do find you need to tap your retirement savings early: You can always withdraw your contributions without having to pay taxes or penalties. That makes it a much more flexible savings option. Just try not to dip into the earnings portion of the account before it’s been open for at least five years and before you reach age 59½. If you do, you may have to pay a 10-percent early withdrawal penalty, on top of taxes. (Certain situations, like buying a first home or paying for qualified education expenses, are exempt from this rule, so you can avoid the penalty.)
When would a traditional IRA be the right choice?
A traditional IRA may make more sense for you if you qualify for the full deduction now and you think your tax rate will be lower when you tap the account. That might be the case if you know you’ll fall to a lower tax bracket once you’re retired and making your withdrawals.
You might also go the traditional route if you’re not eligible to contribute to a Roth. To max out a Roth IRA contribution in 2020, your MAGI must be less than $124,000 if you’re a single filer, or $196,000 if you’re married and filing jointly. Traditional IRAs have no income limits on making contributions, but do have income limits for being able to deduct those contributions from on your taxes.
So should I go with a traditional or Roth IRA?
Why choose just one? You can use both account types in your overall retirement savings plan. Since you can’t predict the future (right?), many experts recommend hedging your bets and diversifying your tax advantages. For example, if you have a traditional 401(k) through your employer, you may opt to go with a Roth IRA, too. That way, you have your bases covered no matter what happens with your tax situation over time.
You can even have both a traditional IRA and a Roth IRA. Note though that contribution limits apply for all your IRAs. So if you do decide to use both account types, you can still only contribute a total of $6,000 between them in 2020 (or $7,000 if you're 50 or older).
No matter which type of account you use, the most important thing is that you're saving for retirement and in a tax efficient way.
Investing involves risk including loss of principal. Past performance does not guarantee or indicate future results. This information is being provided for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. You should consult your tax or legal adviser regarding such matters.