An individual retirement account (IRA) is an investment account with tax advantages that allow investors to save and invest for their retirement.
The two main types of IRAs are the Roth IRA and the traditional IRA. The accounts can be invested in stocks, bonds, and other assets. You can own funds such as index funds, mutual funds, and target date funds within an IRA. They are flexible and versatile.
The maximum amount you can contribute towards your IRAs collectively in 2020 is $6,000 for single-filers under the age of 50 and $7,000 for those 50 or older. This amount is not affected if you are already contributing to a 401(k) retirement account.
The traditional IRA and Roth IRA are similar in that they both offer tax advantages to build a nest egg. However, they each come with unique characteristics and rules that are critical to understand.
With retirement a far way out for the majority of people, decisions up front (no matter how small they seem now) can have a substantial impact on your savings and investments.
For a traditional IRA, investors make contributions with pre-tax money. Funds going into the traditional IRA account are not taxed, allowing your entire contribution of funds to grow and compound over the life of the account.
However, when withdrawals are made, the withdrawals are taxed at that time as ordinary income.
Another tax feature of the traditional IRA is that you are allowed to deduct your contributions on your tax returns at the state and federal level.
If your taxable income is $50,000, a $6,000 deduction would reduce your taxable income amount to $44,000.
This feature begins to phase out once your modified adjusted gross income (MAGI) level exceeds a certain threshold.
You can begin withdrawing from your account penalty free once you hit age 59 ½. You aren’t obligated to begin withdrawing at that age but you have the option to. Once you hit age 72, you are required to begin taking minimum distributions.
A Roth IRA is one of the more popular individual retirement accounts due to its unique tax features.
With a Roth IRA, you’re contributions to the account are taxed up front and your accounts can grow through the years tax-free. This means that when you withdraw for retirement, you won’t have taxes to pay on what you gained.
This is the main attraction for the Roth IRA. By paying your taxes up front, the remainder is free to compound over the decades you hold the account. You’ll find comfort knowing that you won’t have a large tax bill for any withdrawals. You just have to abide by the few withdrawal rules which we will go into detail in later.
One downside is that you cannot deduct your contributions to your Roth IRA account against your taxable income. That feature is offered through a traditional IRA.
One stipulation of the Roth IRA is that you cannot begin withdrawing from your account tax-free until 5 years have passed since the tax year of your first contribution. This applies to investors even past the age of 59 ½.
It is important to note that opening an IRA does not require you to choose one or the other. You can open both a traditional IRA and a Roth IRA. Whether you have one account or both, the total maximum amount of contribution remains the same.
If you have two accounts (a traditional and a Roth), your maximum contribution to both combined will be $6,000 (for single filers under age 50).
Below are some similarities between the two:
- Both are retirement accounts that allow you to contribute up to $6,000 per year for single-filers up to 50 years old and $7,000 for those 50 and older.
- Both have some sort of tax benefit to investing in them and both offer a wide variety of investment options.
- Depending on who you open an IRA account with, the fees and minimum funding to open an account can be the same.
|Roth IRA||Traditional IRA|
|Tax benefits||Investments grow tax-free. Withdrawals of contributions and gains are tax-free||Tax-deferred investment growth and contributions are tax-deductible|
|Contribution Sources||After-tax dollars||Pre-tax dollars|
|Contribution eligibility||Anyone with earned income below certain threshold levels||Anyone with earned income. There is no income limit threshold|
|Contribution age restriction||No age restrictions||After the SECURE Act of 2019, investors can contribute to a traditional IRA at any age. Previously, investors over 70 1/2 could not contribute after that age|
|Early Withdrawal Penalties||If withdrawals on earnings are made before age 59 1/2, taxes will be paid on earnings plus an additional 10% tax. Account age must also be at least 5 years||If withdrawals of contributions and earnings are made before 59 1/2, a 10% penalty tax will need to be paid|
|Withdrawal taxes||No taxes paid when investor withdraws contributions. No taxes paid on investment gains either. If withdrawal rules are broken, taxes will be paid on earnings plus a 10% additional tax. There are no penalties for withdrawing contributions||Taxes are paid on withdrawals of pre-tax contributions. Taxes are paid on withdrawals of earnings. Both are taxed as ordinary income.|
|Mandatory distributions||No required minimum distributions||Required minimum distributions must be taken by April 1st of the year after you reach age 72.|
Which is the Best Option?
The better option between a traditional IRA and a Roth IRA will depend on the individual, their circumstance, and what benefits they want.
Putting eligibility for the two aside, the deciding factor will be which option’s tax benefits are more valuable to you. You’ll have to decide when and how you want to be taxed.
If you are in a lower tax bracket today and expect to be in a higher tax bracket once you begin taking withdrawals, a Roth IRA could be the better option. You can pay taxes on your contributions today at a lower tax rate and withdraw your investments tax-free when you are older and in a higher tax bracket.
If you are in a high tax bracket today and expect to be in a lower tax bracket in the future when you begin taking withdrawals, a traditional IRA may be the better option. You can receive more benefits by taking deductions up front. Once you withdraw, you’ll pay taxes at a lower tax rate.
When you decide on which one to open, first determine your eligibility. For both, you have to have taxable compensation in order to contribute.
However, for a Roth IRA, the amount you are able to contribute can be restricted depending on your level of modified adjusted gross income (MAGI). The restrictions differ based on your filing status as well. See the table above in the Roth IRA section.
If your income exceeds a certain threshold, you will not even be able to make any contributions to a Roth IRA account.
For a traditional IRA, there are no income limits in order to make contributions to an account, but there are income limits for the tax deduction amount you can claim for your contributions.
Prior to 1/1/2020, an individual over the age of 70 ½ could not contribute to a traditional IRA. With the SECURE Act of 2019, the age limit was removed.
Flexibility will also need to be considered. The Roth IRA has more flexibility with withdrawals on contributions. With a Roth IRA, the investor is able to withdraw their contributions at any time penalty-free.
Note: this is for withdrawal of contributions, not earnings. If withdrawal of earnings are made before age 59 ½, taxes will be paid on the earnings with an additional 10% tax penalty.
The Roth IRA is more flexible because a traditional IRA will not let you withdraw your contributions OR earnings early without a tax penalty.
Where to Open an IRA Account
There are many options for signing up for an IRA including:
- Brokers like TD Ameritrade or Charles Schwab
- Banks, credit unions, and financial institutions
- Mutual fund providers and investment companies
- Robo advisors like Betterment or Wealthfront
The best option to open an account will depend on the fees you are willing to pay and how much help you want managing your investments. If you are a hands-on investor, you may want to open an account where you can control your investment choices a little more.
This will probably result in lower fees as well. For a professionally managed IRA, it will be a more hands-off interaction for you, but will likely come with higher fees for the management of the account.
To make the process automatic, robo advisors are becoming increasingly popular and are much cheaper than hiring an actual human to manage your funds.
Requirements to open an IRA account
- Must have earned income
- Some come with minimum funding requirements
- The IRS doesn’t particularly require a minimum investment. It is up to the provider of the IRA
1. Begin saving and contributing as early as you can
- Allow time and the power of compounding to work in your favor.
- Don’t be discouraged if you can’t contribute the maximum amount ever year. Any contribution is better than no contribution.
2. Refrain from taking early withdrawals to avoid penalty fees
- Taking early withdrawals should only be done as a last resort.
- When you take early withdrawals, you will take a hit on the penalty fees you will have to pay. You will also take a hit on the additional appreciation your investment could have achieved if the funds remained invested in the IRA.
3. Minimize IRA account fees
- These are the fees that are related to having an account open with an IRA provider.
- These fees can include management fees, advisory fees, trading commissions, custodial fees, and transfer fees.
- Research on the front-end of your investment process to decrease fees (even if only a few percentage points) can save you thousands, maybe even millions over the time you are invested.
4. As your income rises, it may make sense to convert your traditional IRA into a Roth IRA
- This could make sense if you believe you are likely to be in a higher tax bracket once you begin taking withdrawals.
- A conversion from traditional to a Roth IRA will require the payment of taxes, but the benefits could possibly outweigh the cost in taxes to convert.
Opening up an IRA account is a great option to save and invest for your retirement. While both are solid options, the optimal option for you will depend on a variety of factors pertaining to your situation and goals.
Before making any investment decisions, do your own research and consult with an investment professional if you have access to one.
Doing this before funding an IRA account will ensure you make the best decision possible to achieve your financial goals.