Traditional vs. Roth IRA
What do you think of when you hear “retirement”? Even if you are nowhere near retirement age, I encourage you to day dream for a moment. What do you think your retirement will be like? When many of us think of our future retirement, we think of long walks on the beach, leisurely lunches with friends, finally finishing that stack of books, or spending more time with family. But unfortunately, that’s not the reality for many Americans. With cost of living rising, and savings decreasing, those peaceful retirement years are looking farther and farther away for many of us. But the good news is, there are things you can do today (literally today!) to help set yourself up for a stable future in your golden years.
What is an IRA?
IRA stands for Individual Retirement Account. This is an account for an individual person to save for their retirement. Both traditional and Roth IRAs are not typically connected to an employer, meaning your ability to put money into your IRA does not depend on a specific employer. You can change jobs at any point and still continue contributing to the same account.
Who can open an IRA?
Anyone who has earned income (i.e. taxable) is eligible to open an IRA. If you file income taxes every year with a W-2 or 1099, you can likely contribute to an IRA. You can also contribute to an IRA if your spouse makes taxable income and you file jointly. Meaning, if you are a stay at home parent, but your spouse works, you can still contribute to an IRA in your own name.
Additionally, students and teenagers with jobs can also contribute to an IRA as long as they have taxable income (if it is less than $6,500, they can contribute up to their income amount). So, babysitting for cash might not qualify, but working as a lifeguard at the local pool would. Contributing to an IRA as a teenager can give you (or your child) decades of compounding growth and set up a very comfortable retirement.
Contribution limits
IRAs have maximum contribution limits, meaning you can only contribute up to a certain amount per year. For 2023, that was $6,500 for anyone under 50 and $7,500 for anyone over 50 (these are called catch-up contributions).
It’s important to note that this maximum applies for all IRA accounts. It is possible to have multiple IRA accounts across different banks, but the contribution maximum is still $6,500. For example, if I have a Traditional IRA in Bank 1, I might contribute $2,000. Then I can contribute $4,500 to my Roth IRA in Bank 2. The total for both accounts is $6,500.
Additionally, you can contribute from January 1st of the present calendar year, until tax day in April the following year. For instance, for 2023 contributions, I have from January 1, 2023 to April 15, 2024 to hit my maximum contributions. This gives you a couple months of extra time to reach those maximum contribution amounts.
Income maximums
Here’s one problem that I hope you all have in the future: high-income earners are not eligible for all IRAs. Typically, anyone can contribute to a Traditional IRA, but Roth IRAs have rules excluding high income earners. In 2023, anyone single or married filing separately, earning less than $138,000 can contribute the full amount to their Roth IRA. For married filing jointly, that amount is $218,000. If you make over that amount, you can contribute a reduced amount or not at all. Make sure to check the IRS.gov webpage for current information because these amounts often change, or find a qualified tax professional that can help you with your specific situation.
Tax benefits
Now, we’ve mainly talked about similarities between Traditional and Roth IRAs. The main difference between Traditional and Roth IRAs is taxes. Both Traditional and Roth IRAs are designed to provide tax benefits. A Traditional IRA you pay taxes later. A Roth IRA you pay taxes now.
For a Traditional IRA, this means you contribute pre-tax dollars directly from your paycheck, which also reduces your taxable income for the year. For example, if I make $50,000/year and I contribute the maximum $6,500 to my Traditional IRA, I will only have to pay income taxes on $43,500. This can be a great way to lower your annual income taxes, while also saving up for your future retirement (that $6,500 is still yours, it’s just sitting in a different account). The catch is that you will have to pay taxes eventually, when you withdraw the money. So when you reach retirement and you are ready to start using the money in your Traditional IRA, you will have to pay income taxes based on your current tax bracket. Meaning that if you are in a higher tax bracket at retirement than you were when making the contributions, you may be paying more taxes on that money.
A Roth IRA, on the other hand, you pay taxes before making contributions. Meaning, I receive my paycheck after taxes/healthcare/additional benefits have been deducted, then I make contributions to my Roth IRA. You receive no tax benefits today, but you do receive them in the future. Because Roth IRA contributions are after-tax dollars, the money you put in, in addition to any growth from investments, can be withdrawn tax-free at retirement. This can be a very appealing benefit for people that expect to be in a higher tax-bracket at retirement, because withdrawals from Roth IRAs are entirely tax-free.
Early withdrawal penalty
You may have heard of something called an early withdrawal penalty. This means, if you want to use that money before age 59 ½, you have to pay a 10% penalty fee, in addition to the income taxes you pay when withdrawing. Now, there are sometimes ways to avoid this 10% fee, such as using the money for qualifying medical expenses, education, or first-time homebuyers. But I recommend you speak to a tax professional before withdrawing to make sure you understand the rules and you won’t have to pay the early-withdrawal fee.
Additionally, you should strongly consider looking for other sources of money before touching your IRA. Remember, this is your retirement we’re talking about. By removing that money today, you are not only paying the 10% penalty fee, but you are sacrificing compounding interest that could be potentially tens of thousands, if not hundreds of thousands more at your retirement. Think carefully whether that withdrawal is worth it.
Minimum distributions
When you reach retirement age, your Traditional Roth has what’s called Required Minimum Distributions (RMD). In 2023, RMDs were required by age 73, but the IRS could raise that age limit at any time. This means, at age 73 you are required to start withdrawing money from your Traditional IRA, and pay taxes on it. If you do not withdraw the money, you’ll pay a penalty. Remember, the IRS wants you to start using that money (and paying the taxes for it).
Since you already paid taxes on your Roth IRA, there are no minimum distributions in retirement. You can keep the money in that account for as long as you desire.
IRA & 401k
Ok, we’ve spent this whole article talking about IRAs, but for many people, their first retirement account is a 401k through an employer. So what do you do if you already have a 401k? The good news is, it doesn’t matter! You can have a 401k through your employer and contribute up to the maximum ($22,500 in 2023) AND you can have an IRA and contribute up to the maximum ($6,500 in 2023). Meaning, you can contribute up to $29,000 in retirement accounts every year. If you are maxing out both your 401k and your IRA, I applaud you. You are a champion.
Invest your money!
Something really important to note about these accounts is that they are investment accounts NOT savings accounts. When you open your IRA, you should be able to choose certain investments (the variety of investments available to you depends on the bank you use to open your account). But remember, the idea is that this money will grow between now and your retirement. The average growth of the overall market is about 7%, so you want your money to be growing at at least 7% so you have a greater amount available to you at retirement.
Action Items
Can you open an IRA? If you’re not sure, read the first section again or call your bank and ask.
Would you prefer a Traditional (pay taxes later) or Roth (pay taxes now) IRA?
Are you investing the money in your IRA? If you’re not sure how, starting with some basic index funds like a “Total market fund” is a great place to start.
Although this article focused on Traditional and Roth IRAs, there are other types of IRAs available. For information about other types of IRAs, visit IRS.gov. For more information about your specific tax situation, speak with a Certified Public Accountant (CPA). For information regarding your specific financial situation, speak with a Certified Financial Planner (CFP).
Your life may not be perfect, but it is imperfectly yours. The only way to live it is your way.
