What Type of IRA Should I Have?
IRAs, or Individual Retirement Accounts, are an essential part of a sound financial plan for retirement. There are two basic types of accounts: the traditional IRA and the Roth IRA. Chances are you’ve heard of both, but how do you know which one is right for you?
The biggest difference between the two is in how they are taxed. There are also different requirements and restrictions on both types that play a large role in determining whether you would benefit more from a traditional or a Roth, or a combination of the two. Let’s dive in further to determine how both could help you!
The points of comparison
A traditional IRA has the short-term benefit of being tax-deferred. This means you get the benefit of compound interest on more money since it’s not taxed when you contribute. You can deduct the amount of your contributions on both your Federal and State taxes for the year in which you make the contributions, but the money is taxed at the ordinary income rate when you make a withdrawal in retirement.
A Roth IRA is more of a long-term benefit because your contributions are made with after-tax money, then you don't pay taxes when you withdraw. This means the growth in the account is tax-free.
Anyone under age 70 ½ is eligible to contribute to a traditional IRA.
Anyone of any age may contribute to a Roth.
Income Eligibility Restrictions
There are no income restrictions on a traditional IRA, but there are on a Roth.
Currently, single filers must have a modified AGI of less than $137,000, and deductions for contributions begin to phase out at $122,000. Married filers must have a modified AGI of less than $203,000, and contribution deductions begin to phase out at $193,000.
There are no limits to how much you can contribute to a traditional IRA, unless you also have certain types of employer-sponsored retirement plans. Exceeding the limits can be costly, so be sure to check with a qualified financial advisor to see if your employer’s plan makes you subject to them.
Contributions to a Roth IRA have limits based on your income and tax-filing status. The IRS has a handy chart that breaks the limits down here.
A traditional IRA is subject to RMDs (Required Minimum Distributions) beginning at age 70 ½.
Withdrawals from a Roth IRA are not required for the original owner.
Both IRAs allow owners to begin taking qualified distributions at age 59 ½.; however, a Roth is subject to a five-year aging requirement. This means you must wait at least five years after making the first contribution before you can make a withdrawal.
If you have a traditional IRA, are under age 59 ½, and are a first-time home buyer or have qualified medical, higher education, or other expenses, you can withdraw up to $10,000 without paying the standard 10% tax penalty.
If you have a Roth IRA, contributions can be withdrawn penalty-free at any time, even before age 59 ½. Earnings of up to $10,000 can be withdrawn before age 59 ½, but you must pay taxes on the amount withdrawn.
So how do you know which type of IRA is right for you?
As you can see, there are several factors to consider. A Roth IRA is a very powerful tool that many can use to have a greater after-tax return over their lifetime. It can also have advantages for high net worth families with estate tax issues. That being said your tax bracket, other types of retirement accounts you may have, and how close you are to retiring are all critical factors that go into determining which account is best for you. Over the short term your cash flow can benefit from a deferred account and it can be useful to have a variety of tax options to keep your income lower while working and play with your tax bracket while you are retired. In any case, it’s important to talk to a financial advisor who can help maximize your funds in retirement by employing a tax-efficient financial plan.