Article Key Takeaways:
The maximum you can contribute to a Roth IRA and traditional IRA combined is $6,000 (as of 2019). Only individuals under a certain income limit ($137,000) can contribute to a Roth IRA, however, you can get around this (legally, I swear!) by using a backdoor Roth IRA.
On a high level, a Roth IRA may be suitable for:
- Individuals who anticipate having a higher tax-rate at retirement than they do today
- Individuals who are planning to retire significantly before the age of 59 ½
- Individuals who want to grow their investments tax-free
- Individuals who do not want to regularly withdraw distributions after the age of 70½
A traditional IRA may be suitable for:
- Individuals who anticipate having a lower tax bracket when they retire (no earlier than 59 ½) than they do now
- Individuals who want to save for retirement, but have AGI (Adjusted Gross Income) too high to contribute to a Roth IRA
- Individuals who are trying to decrease their taxable income
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So you’re thinking of saving for retirement. Nice job! How do you plan on getting started? You can invest in an IRA, a 401k, or both. The primary difference is that anyone who makes taxable income (i.e you’re employed) can contribute to an IRA. If you want to open a 401k, you would have to do so through your company.
The annual maximum you can contribute to an IRA is $6,000* if you’re under 50, and can be divided between a Roth IRA and/or a traditional IRA. The type of account you choose depends on your individual needs.
Roth IRA
Roth IRAs are funded with after-tax money, the money you have in your pocket after taxes are deducted from your salary. Under a Roth IRA you are not required to make minimum distributions from your account after 70 ½, which means your money can continue earning that sweet sweet interest. You cannot contribute to a Roth IRA if your MAGI (Modified Adjusted Gross Income) is greater than $137,000*, unless you set up a Backdoor Roth IRA. There are two powerful reasons for investing in a Roth IRA, if you are under the income limit:
1. Your investments grow tax-free.
As an example, let’s consider what would happen if we made a one-time investment of $10,000 today at a safe 6% annual interest rate for 20 years:
The beautiful thing about this is that your investment earnings grew tax-free. A Roth-IRA is funded with your after-tax amount of $10,000 and when you take out that $32,072 at retirement, it’s all yours to keep. If you’re like most people, however, you don’t make a one-time investment, you continually add to your account overtime. That would make your investment earnings look closer to this:
The power of compounding interest is immense and a Roth IRA allows it to work its full, tax-free magic on your retirement savings. This is not the case with a traditional IRA! With a traditional IRA you would have to pay tax on principal (what you put into the account) and any interest earnings that the account generated.
2. You can withdraw your principal (but not your interest) from your Roth IRA before the age of 59 ½ penalty free.
59 ½?! If you’re like most people, that means you’ve been working almost 40 years, maybe more if you count that under-the-table candy business you ran when you were in high school. If you’ve worked hard and built up a nice nest egg for yourself, you may want to tap into those funds sooner, whether it be retiring early or supplementing your income. While there is a 10% penalty for withdrawing earnings on investments before the age of 59 ½, you can withdraw principal tax-free at any time, so long as your principal has been sitting in your Roth IRA account (or aging, like a fine cheese) for at least 5 years. The Roth IRA can be a powerful tool for people who plan to retire early.
On a high level, a Roth IRA may be suitable for:
- Individuals who anticipate having a higher tax-rate at retirement than they do today
- Individuals who are planning to retire significantly before the age of 59 ½
- Individuals who want to grow their investments tax-free
Traditional IRA
The other type of IRA is a traditional IRA, which has no income limit – anyone who makes taxable income can contribute to one. A traditional IRA also has several benefits:
1. Contributing to a traditional IRA can help you decrease your taxable income.
A traditional IRA is a pre-tax funded retirement account: if you had taxable income of $85,000 and you made a $5,000 contribution to your traditional IRA, you would decrease your current taxable income to $80,000. Depending on your income level and how much you contribute, you could save a few hundred dollars on tax payments. Keep in mind that the maximum contribution you can make to your traditional and Roth IRA accounts combined is $6,000, so the amount of tax savings you receive is relatively small, but could still be worthwhile!
2. Traditional IRAs are funded with pre-tax dollars, allowing you to increase the size of your initial investment.
The money that you put into a traditional IRA is pre-tax, so you can put your money to work sooner. Assuming that you’re in the 25% income tax bracket, the same $10,000 that you put into a Roth IRA would be worth $10,000/(1 – TaxRate) = $13,333 in your traditional IRA. Let’s invest that over the same 6% annual interest rate for 20 years that we did for the Roth IRA.
The additional initial principal increased our future balance by around $10,000, but you would have to pay tax on that balance when you withdraw it. The amount you withdraw is treated as ordinary income, so if you withdrew $100,000, you would be taxed at the income bracket for $100,000 plus whatever other income you made that year.
Although you cannot withdraw money from a traditional IRA before the age of 59 ½ without a 10% penalty, there are some exceptions. You can use traditional IRA funds to pay for higher education expenses or $10,000 towards the purchase of your first home. This article from Nerdwallet sums them up nicely.
In short, a traditional IRA is suitable for:
- Individuals who anticipate having a lower tax bracket when they retire (no earlier than 59 ½) than they do now
- Individuals who want to save for retirement, but have AGI (Adjusted Gross Income) too high to contribute to a Roth IRA
- Individuals who are trying to decrease their taxable income