When it comes to Roth vs. Traditional IRAs, are you well-versed on the differences? Understanding how each operates is important for tax planning and when determining where to allocate your hard-earned money.
The primary differences come down to taxes and timing. Let’s dig into the details so you can make educated decisions and avoid any tax-related surprises.
Tax Overview
A Roth IRA is funded with after-tax income. By paying the taxes today, your account grows tax-free and you keep 100% of your money when withdrawn after 59 ½.
Think about your future. Is it likely you’ll be in a higher tax bracket at retirement compared to today? It’s this scenario that leads people to choose a Roth retirement account. Your total taxes paid on contributions will be lower using today’s tax rates compared to those of the anticipated future.
On the contrary, a Traditional IRA is funded with pre-tax earnings. Your withdrawals down the road will be taxed as income. But due to career trajectories or the simple passage of time, don’t most people expect taxes to rise over time? Why would you willingly sign-up to pay higher taxes in the future?
With a Traditional Individual Retirement Account, you gain an immediate tax benefit. Contributions made in a year are tax-deductible; lowering your gross annual income. If you think your tax bracket will fall when you are in retirement you would want to select a traditional IRA today.
Max Annual Contributions
Traditional and Roth IRAs play by many of the same rules. In 2021, an individual can contribute $6,000 into their IRA if they are under 50-years-old. If 50 or older, you can contribute $7,000.
Either by choice or through roll-overs, you may end up with more than one IRA. Regardless of the type or number of IRAs you have, your combined contributions into all Individual Retirement Accounts cannot exceed the $6,000 or $7,000 annual limit.
That being said, these limits do not affect your contributions to your 401k, other work-sponsored retirement accounts, or other investment and savings accounts.
How To Choose
Are you intrigued by the immediate tax break associated with the Traditional IRA? Or would you prefer tax-free withdrawals down the road? You’ll have to crunch some numbers and review your tax return to determine which is right for you.
While young investors may be easily drawn to a Roth IRA, the immediate tax break of a Traditional IRA becomes more and more intriguing as you climb the tax bracket ladder. A tax accountant or financial advisor can assist in guiding you to which is best for you.
Rules And Penalties Associated With IRAs
Like any account with tax benefits, there are rules. When it comes to IRAs, there are income limits where your tax benefits begin to diminish or you may no longer qualify.
The limit is based on your Modified Adjusted Gross Income (MAGI). Your MAGI is your gross income as stated on your tax return plus pre-determined deductions added back in.
For 2021, the following limits are in place for IRA owners that are covered by a work-sponsored retirement plan:
Married couples filing jointly with a MAGI between $105,000 to $125,000, will receive a partial deduction. If over $125,000, you no longer qualify.
Single tax filers with a MAGI between $66,000 and $76,000 receive partial deductions. Those over $76,000 no longer qualify.
IRAs also come with a required minimum distribution. Meaning you can’t keep funds in an IRA indefinitely and must begin taking withdrawals when you reach 72 years of age. To learn more about calculating your MAGI and determining your benefits, visit the IRS.gov website or review with a tax professional.
Weigh Your Options
At the end of the day — an IRA can help minimize your lifetime tax bill. We advise many of our clients to take full advantage of the tax savings benefits associated with Roth and Traditional IRAs.
While annual contributions are capped, it's important to remember IRAs are just one of many options you can use to build your retirement nest egg. If you’re ready to assess your retirement savings options, contact an Integrated Wealth Management Financial Advisor. We offer free consultations to learn if our services are right for you.