How do you decide between the traditional IRA and Roth IRA? Which one to use?
Not all retirement accounts are equal.
In this post I want to cover the basics of individual retirement accounts IRA and Roth IRA and why these accounts are very important in retirement planning.
Traditional IRA vs. Roth IRA basics
Let’s start with a traditional IRA.
IRA is an Individual Retirement Account which plays a big role in our retirement savings plan. I am positive that many readers of this blog already have at least one.
Most of the people open an IRA account when they go from one job to another and take the money from a 401(k) plan with them. You cannot withdraw 401(k) money without being penalized before you turn 59 ½ years old.
That’s where traditional IRA account becomes very handy. You can roll over your money from a 401(k) plan to IRA account without a penalty fee. That’s why it’s called a roll-over IRA.
Another name for an IRA is a “tax-deferred account”. It works the same way as a 401(k) plan.
The money you put in this account is not taxed until you start withdrawing them.
The biggest benefit of an IRA account is a tax benefit. The money invested in IRA accounts grow free for the long run and accumulates in a nice nest egg.
Roth IRA is an individual retirement account with no immediate tax benefit.
The money you contribute to Roth IRA is after-tax money. So, you will pay taxes on the money you put in Roth IRA account. But then the money generates in this account is never taxed again.
Both IRA and Roth IRA are investment accounts.
You have an option of opening these types of accounts with your favorite brokerage firm and invest money in stocks, bonds, mutual funds, ETFs and other types of investments.
You can buy and sell investments within IRA and Roth IRA on your own, like do-it-yourself investments. So, you have better control of your investment decisions than with 401(k).
Contribution limits to IRA and Roth IRA
A contribution is an amount of money you put in out of your earned income each year.
IRA roll-overs do not count as a contribution. So, the roll-overs will not affect your ability to fund an IRA account.
You must have earned income to make an IRA contribution.
This means if you are retired or not working, you cannot add money to your IRA account. But you can still roll-over or transfer money from 401(k) to an IRA.
- If you don’t have a 401(k) plan where you work, you can put up to $5,500 into an IRA and $6,500 if you are over 50. (Note: in 2021 you can contribute up to $6,000 a year or $7,000 if you are over 50). Then you deduct IRA contributions on your annual income tax return.
If for example, you earn $50,000 a year and put $6,500 into a traditional IRA, you can deduct the contribution from your federal income tax (meaning you will have to pay tax on only $43,500 to the IRS).
$50,000 income – $6,500 (IRA) = $43,500 (taxable)
- If you have a 401(k) plan offered by the employer, you can still contribute to an IRA, but it depends on your earned annual income. You have to look at income limits on both IRA and Roth IRA.
Roth IRA doesn’t offer an immediate tax deduction, and money is contributed on an after-tax basis.
What to do if you want to contribute money to both IRA and Roth?
This $5,500 or $6,500 contribution can be all in one account or split out between both accounts. Here is a simple example:
- $6,500 IRA, $0,00 Roth IRA
- $0,00 IRA, $6,500 Roth IRA
- $1,500 IRA, $4,00 Roth IRA
- $5,000 IRA, $1,500 Roth IRA
The 2019 combined contribution for IRA and Roth IRA per year is $6,000 or $7,000 if you are over 50. (Note: the 2021 and 2020 combined annual contribution limit for IRA and Roth IRA is $6,000 or $7,000 if you are age 50 or older).
Both retirement accounts offer many advantages. How to decide which account is to be funded first?
Traditional IRA or Roth IRA?
There is no right or wrong answer to this question. Everyone has their own financial situation.
The main difference between the two accounts comes down to one question:
Do you want to pay taxes now with Roth IRA or you want to pay it later with traditional IRA?
If you want to reduce taxes right now, IRA might be a better choice for you. Most of the people over 50 are in the peak earning years and want to take advantage of a tax break.
When we stop working and retire, most of us will be in a lower income tax bracket. So, when we start withdrawing money from 401(k) and IRA accounts we will pay fewer taxes.
But if your income is higher than IRS limitation and you’re not eligible for a deductible IRA or you think you may be in a higher tax bracket in retirement, a Roth IRA might be your better option.
Roth IRA doesn’t offer an immediate tax break. But Roth contributions and their investment gains will never be taxed again.
The best part is you can take money out of Roth IRA account without a penalty fee if you are over 59 ½ years old. It’s a great place to invest money for extra cash and give yourself a huge tax break in the future.
Summary of IRA and Roth IRA:
- An immediate tax deduction for eligible participants (check your income limit)
- Investments grow on a tax-deferred basis (you will be taxed when you start making withdrawals)
- Contributions up to age 70 ½ (you must have an earned income)
- You are required to start minimum withdrawals by age 70 ½ if you were born before 1949, or 72 if you were born after.
- Tax-free growth (money contributed to Roth IRA is taxed, but the distributions in retirement are not taxed). There are certain IRS rules you need to follow.
- No age limitations on contributions (you must have an earned income)
- There are no required minimum withdrawals based on age
- Allows to be passed to your heirs
Both traditional IRA and Roth IRA retirement plans offer tax benefits. The ability to participate in both plans are dependent on a couple of factors, including your annual earned income and whether you have another tax-advantaged retirement plan, like 401(k).
- The traditional IRA allows us to make tax-deductible contributions to the plan and then pay taxes later on our withdrawals.
- While the Roth IRA allows us to make after-tax contributions and then tax-free withdrawals.
One way or another by participating in these retirement plans we try to take advantage of tax reduction and let our investments grow for a long time.
When you start saving for retirement, the employer’s 401(k) plan is the first and best place to contribute money. If you don’t have the ability to participate in 401(k), open the IRA account and start contributing money there.
If you have both 401(k) and IRAs accounts, Roth IRA is also a great place to put away extra cash.
If you have multiple IRA and Roth accounts, make sure that deposits are automatic throughout the year. Save yourself a hassle at a tax time.
Whatever you do, know that you are better off contributing to any IRAs than you would be not using one at all.
What do I use?
I am planning to make some changes to our retirement accounts in 2019. Our financial situation has changed over the years. In 2018 we finally paid off the remainder of our daughter’s student loans. We had several of them with all high interest rates. It took years to slowly minimize the amount of money on each. But in 2018 we decided that it will best for our finances to get rid of them in 12 months.
So, we started with the highest interest rate loan and paid it off with extra payment to each month. Then we turned to the next one. Finally, we made the last payment on December 31, 2018. It felt really good.
Even we still have a few credit card debts and personal loans we are working on paying them off fast. So, we will have extra money to invest in our retirement accounts.
- Add $7,000 to my Roth IRA for 2018 income tax return
- Add $7,000 to Roman’s Roth IRA 2018 tax return
- Increase contributions to 401(k) plan. Roman and I have 401(k) plans. Both of us contribute 15% of our annual earned income. My 401(k) has an employer match up to 6% which brings extra money. But overall we are far away from maxing out our 401(k), which would be $48,000 per year. In 2019 we are planning to increase our contributions by small increments like 2 to 3% percent.
I hope this helps you better to understand the IRA vs. Roth IRA plans. In addition, if you need any further reading, there is a good article from Fidelity explaining everything even in more details.
Related article from Fidelity Investments: Traditional or Roth IRA, or both?
Related Post: Why You Need to Max Out Your 401(k)
It can be still quite complex for you to decide and figure out all limitations. So, if you still need clarification or advice on what to do with all these retirement accounts, I suggest you work with CPA or Certified Financial Planner who can help you better understand which plan may be right for you.
What accounts do you use for your retirement savings?
The opinion voiced in this post are for general information only. I am not providing any specific advice or recommendations to any of my readers.
I really enjoyed this post. It’s very informative. I think that Roth IRA should play a part in everyone’s financial plan. People focus way too much on the tax deduction of traditional IRAs. Having a tax free income from Roth in retirement is a great way to go.
I totally agree with you Sarah. To have a tax free income from Roth IRA in retirement is important for many of us. That is why my husband and I try to max-out our Roth IRAs every year. Thank you for your comments!