IRAs are a great way to contribute money and save for your retirement on a tax-deferred or tax-free (in the case of a Roth IRA) basis. IRAs are also a great destination if you are looking to roll the money over from an employer-sponsored retirement plan like a 401(k) when leaving an employer.
We will take a look at the similarities and differences in the two types of IRA accounts to help you make informed choices about using IRAs for your retirement savings.
Traditional IRA vs. Roth IRA
Before deciding whether to use a traditional IRA, a Roth IRA or a combination of both, it's important to understand how they work.
- A traditional IRA can be funded with either pre-tax or after-tax contributions, or a combination of both.
- Earnings on the money within a traditional IRA account grows tax-deferred until withdrawn.
- Money contributed after-tax will not be taxed when withdrawn, though you will need to keep track of these contributions.
- Withdrawals are taxed as ordinary income; a 10% penalty may apply if you withdraw money prior to age 59½.
- Required minimum distributions must begin at age 70½.
- All contributions are made on an after-tax basis, they are not tax deductible at the time of contribution.
- Earnings on the money invested in a Roth IRA account grow tax-free if withdrawn.
- Qualified withdrawals from a Roth IRA are tax-free. Non-qualified withdrawals may be subject to income taxes and a 10% early withdrawal penalty in some cases.
- There are no required minimum distributions.
For 2019, the contribution limits for IRAs are $6,000 with an additional $1,000 catch-up contribution available for those who are 50 or over at any point during the year. This amount can be divided between Roth and traditional accounts if desired, but the total for all IRA contributions cannot exceed $6,000/$7,000.
This is an increase from the 2018 levels of $5,500 and $1,000. IRA contributions for the 2018 tax year must be made by April 15, 2019.
Generally, the contribution limits for total IRA contributions for each person are the lesser of $6,000/$7,000 or the amount of income earned from employment or self-employment.
There are income restrictions for both pre-tax traditional IRA contributions and for Roth IRA contributions. For 2019, those are:
Traditional IRA Income Limits
If you are covered by a retirement plan at work, such as a 401(k) plan, then the income limits for making a pre-tax contribution to your traditional IRA are:
- Modified adjusted gross income (MAGI) of $64,000 or less - you receive a full deduction up to the amount contributed
- MAGI greater than $64,000 but less than $74,000 - the pre-tax amount is prorated.
- MAGI greater than $74,000 - no pre-tax contributions can be made.
Married filing jointly:
- Modified adjusted gross income (MAGI) of $103,000 or less - you receive a full deduction up to the amount contributed
- MAGI greater than $103,000 but less than $123,000 - the pre-tax amount is prorated.
- MAGI greater than $123,000 - no pre-tax contributions can be made.
For those who are married but file separately the rules get more complex. If you lived apart from your spouse for the entire year then you can use the single filer limits. If you lived with your spouse for any or all of the year, the limits are much more restrictive. Between $0 and $10,000 MAGI there is a phaseout, with no pre-tax contributions allowed for MAGI of $10,000 or more.
For non-earning spouses with a working spouse who is covered by a workplace retirement plan, the 2019 income limits for pre-tax contributions are:
- MAGI of $193,000 or less - you receive a full deduction up to the amount contributed
- MAGI greater than $193,000 but less than $203,000 - the pre-tax amount is prorated.
- MAGI greater than $203,000 - no pre-tax contributions can be made.
Where pre-tax contributions are limited by income, total IRA contributions among all types of accounts are still allowed up to the applicable limits that apply to your situation.
Roth IRA Contribution Limits
The difference in Roth IRA contribution limits are as follows:
- Modified adjusted Gross Income (MAGI) of $122,000 or less - you can contribute up to the full amount allowed.
- MAGI greater than $122,000 but less than $137,000 - the contribution amount is prorated.
- MAGI greater than $137,000 - no Roth contributions can be made.
Married filing jointly:
- MAGI of $193,000 or less - you can contribute up to the full amount allowed.
- MAGI greater than $193,000 but less than $203,000 - the contribution amount is prorated.
- MAGI greater than $203,000 - no Roth contributions can be made.
For those who are married but file separately the rules get more complex. If you lived apart from your spouse for the entire year then you can use the single filer limits. If you lived with your spouse for any or all of the year, the limits are much more restrictive. Between $0 and $10,000 MAGI there is a phaseout, with no Roth contributions allowed for MAGI of $10,000 or more.
Non-earning spouses can contribute to a spousal Roth IRA subject to the appropriate income limitations.
In order to contribute to an IRA account, you must have earned income for the tax year involved. This means income earned from employment or from self-employment. It does not include investment income, or income from dividends, interest, gambling or other non-earned sources of income.
As noted above, non-working spouses whose spouse is working can open ether a traditional or Roth spousal IRA.
Distributions for Traditional IRAs work as follows:
- All distributions made from a traditional IRA account are taxable at ordinary income rates with the exception of the amount of post-tax contributions.
- Money distributed prior to age 59½ is subject to a 10% penalty, with a few exceptions: The value of post-tax contributions Distributions related to your disability or made by your heirs in the event of your death. Distributions to cover healthcare costs unreimbursed by health insurance or to pay health insurance premiums in some cases. Distributions to cover higher education expenses. Withdrawals to cover the cost of buying a first home for you or certain family members, subject to limitations. A series of substantially equal payments that lasts for at least five years and ends when you are at least age 59½.
Distributions for Roth IRAs:
Its important to understand the 5-year rule with regard to distributions from Roth IRAs. This rule states that your first contribution to any Roth IRA account must have occurred at least five years before the first distribution. The 5-year rule assumes the beginning of the year in which the first contribution occurred.
Qualified distributions are tax and penalty-free, have met the 5-year rule and:
- You are at least age 59½
- The distribution is connected to your death or disability
- It is for a qualifying first-time home purchase by you or a qualifying family member
Distributions that will incur taxes on any earnings in the account, but no penalty include:
- The distributions are part of a series of substantially equal payments for a minimum of five years or until you reach age 59½, whichever is longer.
- For unreimbursed medical expenses exceeding 10% of your adjusted gross income
- For the payment of medical insurance premiums if you have lost your job
- For the cost of higher education expenses for you and/or a family member, but not to exceed this amount.
- Payment of an IRS levy
- For a qualified reservist distribution
- For a qualified disaster recovery distribution
Note that your basis in the Roth IRA can always be withdrawn tax or penalty free.
Which Type of IRA Is Best for You?
As with most things in the financial planning and investment world, the answer depends upon your situation.
Some things to consider:
- If you feel that you will be in a higher tax bracket in retirement than when you are working, the benefit of tax-free withdrawals from a Roth could be more beneficial than a current tax-deduction.
- Younger workers whose salary and tax bracket are not that high might consider a Roth.
- If you have money in a traditional pre-tax retirement account at work, you will need to open a traditional IRA account to receive any rollover from the plan.
- Roth IRAs offer the additional advantage of not being subject to required minimum distributions which can be an effective estate planning tool.
As mentioned earlier, you can mix and match contributions between Roth and traditional IRA accounts as needed.
Whichever type of IRA account you choose, IRAs should be a central part of your retirement savings strategy. They offer a potential current tax break, tax-deferred (or tax-free) growth of your investments, tax-free withdrawals (for Roth accounts) and a planning tool for rollovers from qualified employer retirement plans.