Making the decision to save for retirement should be simple: If you save part of your income now and live on less than you make, someday you will be able to retire and hopefully maintain your standard of living, using the money you have saved.
Often, we can do this through our workplace retirement plan, such as a 401(k) or 403(b). However, there are times when we need to look outside of our workplace for the retirement saving process. The two standard options for such times are a traditional IRA or a Roth IRA.
Either account will elevate your financial and retirement planning above doing nothing at all, but understanding the basics of when to use each account could provide additional benefit both now and in the future.
Similarities of the Traditional IRA and Roth IRA
Qualified Retirement Plans
Both a traditional and Roth IRA are qualified retirement plans, meaning they qualify for particular tax benefits by meeting requirements set by the IRS tax code for retirement plans.
In both cases, you put money into the account, and any investment income the account produces, including both dividend income and investment growth, accumulates without producing any additional, current taxes.
The IRS limits the amount that you can contribute to your IRAs each year. For 2021, the maximum contribution amount is $6,000, limited to an amount equal to your earned income.
Contributing to an IRA boils down to this: To save into an IRA, you have to be earning money. Unearned income, such as passive rental income, Social Security, or unemployment, does not count.
An exception is made for married couples who file a joint tax return when one spouse has no earned income—the most common example being a stay-at-home parent. In that case, the nonworking spouse can contribute to a spousal IRA up to the same limits as if they were earning an income.
There is an additional catchup provision for IRA contributions. If you are 50 or older, you can save an extra $1,000 per year toward retirement. The goal is to allow you to save more as you enter your potentially highest income-earning years and as you get closer to retiring.
IRA contributions can be made for any given tax year up until the tax filing deadline.
Withdrawal Limitations and Penalties
Because IRA accounts are designed to help you save for retirement, penalties are assessed if you make a withdrawal early, currently defined as a withdrawal before age 59 ½.
The early withdrawal penalty is set at 10% of the distribution, with a few exceptions made for situations such as certain medical expenses, disability, or higher education.
There are nuances to the withdrawal rules for Roth IRAs (the five-year rule, withdrawal of basis, etc.), but the bottom line is that the accounts are designed to be used for income in retirement. The IRS wants you to wait until retirement to withdraw from the accounts and generally penalizes you for doing otherwise.
The main differences between a traditional IRA and Roth IRA are tax treatment in the current year and tax treatment when taking withdrawals from the accounts in retirement.
When you contribute to a traditional IRA, you reduce your current taxable income by an amount equal to your contributions if your income is below certain limits that depend on your tax filing status. In other words, a portion of your income equal to your contribution amount escapes current-year taxation.
As we already established, when the account grows due to market gains and dividends, that money also grows without any current-year tax implications (known as tax deferment.)
Essentially, this means not a single dollar inside of the traditional IRA has ever been taxed. However, the flip side is that as you withdraw money from the account in retirement, the distributions are 100% taxable. The tax treatment is similar to when you were working and earning an income.
Now, contrast that with a Roth IRA.
When you contribute to a Roth IRA, you use “after-tax” dollars. You get no current-year tax deduction, and you pay income taxes on the amount you contribute.
As with a traditional IRA, all growth in the account escapes current taxation, but here is what makes a Roth so enticing—when you make withdrawals in retirement, they are entirely tax-free!
Because you paid taxes as you went on the contribution amounts, you never have to pay taxes on any growth.
When to Use Each Account
There are a host of other financial planning considerations when deciding how to fund your retirement, but the question for IRAs comes down to this: “In any given year, does it make more sense for me to take advantage of a tax benefit today in the form of a tax deduction (traditional IRA), or can I pay more taxes now to enjoy tax-free income at retirement (Roth IRA)?”
Every person’s situation is unique, and every tax year is different, so there is no “one size fits all” guidance to apply. However, knowing the main characteristics between the types of accounts can help you make a more informed decision on how to best set yourself up for retirement.
Our fiduciary financial planning firm in Spokane, Washington, works with clients to help determine the account types and amounts based on their financial situation and retirement goals. Schedule a complimentary insight meeting to discuss your situation and how we may be able to help.