Starting your first job after college graduation is an exciting time. You have a lot more disposable income. But intelligent workers know it is time to save for retirement with some of that income. When I got my first real job, I started saving for retirement, even as I paid off my student loans and credit card debt. I opened an individual retirement account (IRA) because my small business employer didn’t offer a 401(k) retirement plan.
Ideally, it would be best if you funded your retirement from various sources: Social Security, dividend investments, 401ks, individual retirement accounts, and pension plans. However, only about 20% of Americans have pensions plans, so if you have one, you are lucky! They are not a standard offering from employers anymore. Instead, 401k retirement plans are more common, with 32% of the American workers contributing to an employer-sponsored plan.
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So, What Exactly Is an Individual Retirement Account?
An individual retirement account (IRA) is a retirement savings account intended for use after retirement. They are offered in two versions: traditional and Roth. They are popular because IRAs offer tax advantages not provided by a regular savings account. Also, they are designed for long-term investment.
Anyone who has earned income can open an IRA account. IRA accounts are offered through banks, credit unions, investment companies, financial planners, or brokers. But when comparing a traditional vs. a Roth IRA, differences occur, and these are important to comprehend.
What is a Traditional IRA?
Traditional IRAs were established by the Employee Retirement Income Security Act of 1974 and were originally intended for employees without pensions. The Economic Recovery Act of 1981 made IRA plans available for all workers and spouses. Various changes in contribution levels and withdrawal rules have occurred over the years.
A traditional IRA allows individuals to make pre-tax contributions to retirement investment plans that grow tax-deferred if you have taxable compensation. The account custodians (financial institutions and brokers) invest the funds according to the account holder’s instructions for the account allocation. Simply put, the investor can decide with their advisor what specific stocks, mutual funds, cash, or bonds to invest in according to their tolerance for risk. Capital gains or dividend income taxes are paid upon withdrawal.
There are no income limits for eligibility to invest in a traditional IRA, but there are qualifications for tax deductible contributions. According to the Internal Revenue Service (IRS), whether contributions to a traditional IRA are tax-deductible depends on the individual’s income level and tax-filing status. In 2021 individuals under the age of 50 can contribute $6,000, while those 50 and older can contribute $7,000. Before 2020, you could not contribute to a traditional IRA after age 70 ½. However, starting in 2020, as long as you have taxable compensation, you can continue contributing after age 70 1/2.
Withdrawal Rules and Penalties
Withdrawals can begin as early as 59 ½ years of age, but individuals must take the required minimum distribution (RMD) by 72 years of age. Withdrawals are taxable at the account owner’s current income tax rate. Distributions can be taken before age 59 ½ but are subject to a 10% penalty in addition to state and federal taxes. Exceptions to the 10% penalty rule include first-time home purchase, educational expenses at a qualified institution, disability, death, excessive medical expenses, and health insurance if you are unemployed. Also, new parents can take out up to $5,000 penalty-free from a traditional IRA. But remember, if you withdraw funds, you are reducing future retirement income!
What is a Roth IRA?
Roth IRAs were created as part of the Taxpayer Relief Act of 1997 and named after former Delaware Senator William Roth, the chief legislature sponsor of the act. Contributions to Roth IRAs are taxed when the income is earned. The contributions are not tax-deductible. Your money grows tax-free since you fund a Roth with after-tax dollars.
A Roth IRA allows qualified withdrawals tax-free as long as certain conditions are met. With a Roth IRA, you can withdraw your contributions penalty-free at any time. You will be penalized for withdrawing investment earnings if you are not age 59 ½ or older. Roth IRAs do not have required minimum distributions (RMD). You are not required to take out distributions at any age.
Roth IRA rules allow you to keep contributing no matter how old you are if you have taxable compensation. In 2021 someone younger than age 50 could contribute a maximum amount of $6,000, while someone older than 50 could contribute $7,000 since the federal government allows a “catchup” payment of an additional $1,000.
Are There Income Restrictions on IRAs?
Traditional IRAs have no income restrictions for contribution. You can contribute to a traditional IRA as long as you have earned income (taxable compensation). Your contribution is fully tax-deductible depending on your income, tax filing status, and whether an employer-sponsored retirement plan covers you.
Roth IRAs do have income restrictions. In 2021 single individuals must have a modified adjusted gross income (MAGI) of less than $140,000, with contributions starting to phase out with a MAGI of $124,000. For married couples, the MAGI cap is $206,000, with phase-out beginning at $196,000.
What are the key differences between a traditional vs. a Roth IRA?
The key difference between a traditional and Roth IRA is when you pay taxes on your contributions. With a traditional IRA, you get to deduct contributions that may reduce your adjusted gross income and potentially lower your taxes in the year you made the contribution. You pay the taxes on the withdrawals later. The Roth IRA contributions are taxed in the year of the contributions. You get tax-free withdrawals later in retirement.
The critical factor in determining which type of IRA is best for you is whether you think your income and tax bracket will be lower or higher in retirement. It would be best to consider any income restrictions that may keep you from investing in a Roth IRA.
Potential Roth IRA Bonus for Married Couples!
A tip for newly married couples, an individual can fund a spousal Roth IRA for their married partner who earns little or no income (remember, IRAs are funded from earned income). The couple must be married and file a joint tax return. The same contribution limits and rules apply for contributions for both accounts. In 2021 a couple with a combined income of $196,000 or less could invest a total of $12,000 or $14,000, depending on their ages. The married couple’s Roth IRA accounts must be separate. Roth IRAs cannot be joint accounts.
Final Thoughts Roth vs. Traditional IRA
In my case, the type of IRA I contributed to depended on my income and employer. Initially, I opened a traditional IRA because my taxable compensation and lack of an employer-sponsored plan made the contribution tax-deductible. I also really needed the tax break since I was starting my career and was newly married. As our joint income grew, the immediate tax break qualification no longer applied to my husband and me, and we opened a Roth IRA. We now have a mix of retirement fund accounts, including 401ks, pensions, IRAs, and other investments.
Traditional IRAs or Roth IRAs are just some of the tools you should use to create your retirement plan. Which type of account is right for you will depend on your income, tax-filing status, and when you want to be taxed. Do you want to pay now or later? As we come to the end of the year, you should develop a financial checklist. A certified financial advisor can help you determine the correct type of IRA with the right mix of products to maximize your earnings and minimize your taxes.
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Christine Seaver is a freelance writer that writes about personal finance, budgeting, and debt. She is a frequent contributor at Dividendpower.org. Christine works as an office manager by day and a cookie baker at night. She lives in Massachusetts with her family.