What is an IRA?
IRA stands for Individual Retirement Account. This is a retirement account that is held solely by one individual that allows them to save money for retirement in a tax-advantaged way. Once funds are in an IRA they may be used to invest in stocks, bonds, mutual funds, annuities, Exchange-traded funds (ETFs), unit investment trusts (UITs), and real estate. There are multiple types of IRA accounts such as Traditional IRAs, Rollover IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs, Spousal IRAs, and Self-Directed IRAs. The two most popular IRA accounts are Traditional IRAs and Roth IRAs. This is due to the tax-advantaged status of these two types of accounts. In order to contribute to an IRA, an individual must have earned income that is greater than or equal to the amount contributed to the IRA in a given year. If you are a non-working spouse who makes little or no income annually you are still able to have an IRA through a Spousal IRA. For more information regarding Spousal IRAs please see our article discussing this topic in depth.
IRAs are meant for retirement savings and therefore the IRS has put penalties on the early withdrawal of these funds. If you pull money from your IRA prior to 59 ½ the funds will automatically be included in your ordinary income and will be subject to a 10% penalty (there are a couple of exceptions to this rule).
What is a Traditional IRA?
A Traditional IRA is a retirement savings account where an individual contributes pre-tax dollars to the account. The individual gets a deduction on their tax return for contributing these pre-tax dollars to the IRA in the year the contribution is made. These pre-tax dollars are then able to grow in the IRA tax-deferred until they are eventually pulled out. When distributions are made from a Traditional IRA, they are taxed at the individual’s ordinary income tax rates. The current yearly contribution limit for Traditional IRAs is $6,000 ($7,000 if you are 50 and older).
The tax-deductibility of Traditional IRAs is subject to certain income limits. If an individual or their spouse participates in a workplace retirement plan (i.e., a company 401(k) or 403(b) plan) this can affect the tax deductibility of a Traditional IRA contribution based on their level of income. To see the 2022 table for the phase-out of tax-deductible Traditional IRA contributions please see the table in Appendix A below.
Money contributed to a Traditional IRA can be taken as a tax deduction in the year that the contribution is made.
Traditional IRAs are subject to required minimum distributions (RMDs) when you turn 72 (SECURE Act 2.0 will make this age 73 starting in 2023, 74 in 2030, and 75 in 2033). These RMDs force the owner of the IRA to take a distribution from their IRA every year. This amount is calculated based on the age of the IRA owner and the value of the IRA on December 31 of the previous year.
Also, if you make good investment decisions and the money in your Traditional IRA grows substantially, all of it will be taxable when it is pulled from the IRA.
What is a Roth IRA?
A Roth IRA is a retirement savings account where an individual contributes after-tax dollars to the account. The individual does not get any tax deduction on their tax return in the year the contribution is made. These after-tax dollars are then able to grow tax-free and are not taxed when they are pulled out of the account. The current yearly contribution limit for Traditional IRAs is $6,000 ($7,000 if you are 50 and older). Another feature of a Roth IRA is that you can take your cost basis out of a Roth IRA prior to 59 ½ without penalty. But once you start to pull out the earnings on your account you will face taxes and penalties.
Because the Roth IRA is seen as a more advantageous account to invest in the IRS has put restrictions on who may contribute to a Roth IRA. If you file an MFJ tax return and make over $214,000 in 2022 ($144,000 for single filers) you are unable to contribute to a Roth IRA account. Currently, there is a way for individuals who make over these income limits to still get money into their Roth IRA accounts. This is known as a Backdoor Roth Conversion. For more information on this please see our article outlying what it is, how it is done, and the benefits of doing it.
Roth IRAs allow for individuals to put money into a retirement account that can grow tax-free. This means that no matter if your earnings on the account are$1,000 or $1,000,000 there will be no tax when the money is pulled out of the account.
Roth IRA accounts have income limits that try to keep high-income earners from taking advantage of it. While there is currently a loophole that allows income earners over the limit to still get their annual contribution amounts into a Roth account, it is uncertain if the IRS will try to close this loophole in the future.
Traditional vs. Roth IRA Illustrations
The key issue in determining if you would like to contribute to a Traditional or a Roth IRA is taxes.
With a Traditional IRA, you receive a tax deduction in the year the contribution is made and taxed when the funds are withdrawn. Let us use a scenario to illustrate this. Say Bob age 40 contributed $6,000 to a Traditional IRA and is normally in the 22% tax bracket. The year he makes the contribution he will be allowed to take a tax deduction of $6,000 on his return saving him $1,320 ($6000*22%) on his tax return that year. Then, when Bob retires the IRA is worth $10,000 ($6,000 Bob put in and $4,000 gains). Whenever he pulls out any portion of the $10,000 it will be taxable to him as ordinary income. Say he pulls all $10,000 out of the IRA in one year when he is in the 10% tax bracket (he is in a lower bracket now that he is retired). That $10,000 distribution will be taxed at Bob’s ordinary income rate and create a $1,000 ($10,000*10%) tax. Therefore, by contributing to a Traditional IRA Bob was able to have his $6,000 contribution turn into $10,000 and save $320 in net taxes.
With a Roth IRA, you do not receive a tax deduction when you contribute to it but are able to pull the funds tax-free in retirement. Let us use a scenario to illustrate this. Say Sally has the same set of circumstances as Bob, but she contributes to a Roth IRA instead of a Traditional. The year she contributes the $6,000 to the Roth she will not get a tax deduction and must pay $1,320 in taxes on the funds. Then, when she is in retirement and pulls all $10,000 in one year, she will not have to pay any taxes on the funds pulled and save $1,000 in taxes. In this illustration, it is more tax advantages to put money into the Traditional IRA which saves Bob $320 in taxes whereas Sally ended up paying $320 more in taxes. But let us change the scenario slightly. Say in retirement both of their IRA accounts had grown to $15,000 instead of $10,000. Bob would then have to pay $1,500 in taxes on the withdrawal of the full amount whereas Sally would save $1,500. In this scenario, it would be more tax advantageous to put the money into the Roth IRA where you save $180 net in taxes.
Considerations for Traditional vs. Roth IRA
The scenarios above help illustrate the considerations that need to be considered when determining whether to contribute to a Traditional or a Roth IRA. It is usually more tax advantageous for younger people and people in lower tax brackets to contribute to a Roth IRA. Young people should contribute to a Roth IRA since they will have more time for their funds to grow tax-free. For people in lower tax brackets, it tends to be more beneficial to contribute to a Roth IRA since there are not as many tax savings from the tax-deductible element of the Traditional IRA. On the flip side, it is more tax advantageous for people nearing retirement or who are in higher tax brackets to contribute to a Traditional IRA. People nearing retirement tend to be making the most money they have in their entire careers. This means that they will most likely be paying taxes for the highest tax bracket they will ever be in. This makes the tax-deductible element of Traditional IRAs more advantageous for these older wage earners and high-income earners as they will have more tax savings in the years, they are making their highest income. This also tends to be the case since people’s income usually drops significantly in retirement dropping them to the lowest tax brackets when they start to pull the money out of the Traditional IRA.
Appendix A: Traditional IRA Tax Deductible Phase-Out Ranges