The bad news: Most Americans don’t exactly excel at saving for retirement.
A 2019 study by Transamerica found Americans have a median retirement savings of only around $50,000. That may not even cover one year’s expenses in retirement, let alone 30 years or more.
The good news is that Americans have more options than ever before to save for retirement in tax-sheltered accounts. These options start, first and foremost, with individual retirement accounts (IRAs).
There are two types of IRAs: traditional IRAs and Roth IRAs. Fortunately, you don’t have to choose one or the other; you can open and maintain both.
As you decide how much you want to contribute to which type of IRA, keep the following similarities and differences in mind. And if you don’t know how to proceed, get help from a professional financial planner. If you need help finding someone in your area, you can use a tool from SmartAsset. They’ll ask you a few questions, and then provide you with a vetted advisor in your area.
What Both IRA Types Share in Common
Traditional and Roth IRAs are two sides of the same coin, with far more in common than not.
Before focusing on their differences, you need to understand how they work.
A Brokerage Account With Special Tax Benefits
Ultimately, IRAs are brokerage accounts that happen to offer better tax perks. You open them with a broker like JP Morgan Self-Directed Investing or M1 Finance, just like a regular taxable brokerage account. You then get to buy, hold, and sell securities, like any other brokerage account.
The specific tax benefits vary depending on whether you open a traditional or Roth IRA, but the process of opening an IRA and trading securities looks nearly identical to a regular brokerage account.
You Own the Account
Unlike employer-sponsored retirement plans like 401(k)s or 403(b)s, you completely own and control an IRA.
That means you don’t have to move the money when you change jobs — the account sits with your brokerage, available for you to log in and manage at any time. You can also pick and choose any investments you like, with no limitations based on what your employer plan offers.
Rollovers
When you do change jobs, it usually makes sense to close your employer-sponsored retirement plan and transfer the money to your IRA. You don’t have to, but you risk forgetting about the money if you leave it in the hands of your ex-employer.
This transfer from an employer-sponsored account to your own IRA is called a rollover. Both types of IRAs can be used to roll over funds from an employer-sponsored retirement plan.
Because most employee retirement accounts are funded with pretax contributions, many outgoing employees choose to rollover funds into their traditional IRA to avoid paying tax on the entire amount. Rollovers to your traditional IRA are not taxed, and they don’t count toward your annual contribution limit.
Alternatively, you can roll most pretax retirement accounts, including 401(k)s, into a Roth IRA. This is known as a conversion. However, you then need to include money you converted from a traditional retirement account to your Roth IRA as part of your income on your taxes that year (more on Roth conversions shortly).
Annual Contribution Limits
In 2021, taxpayers under age 50 can contribute up to $6,000 to their IRA (unchanged from 2020). Those 50 and over can contribute $7,000, with the extra $1,000 serving as a “catch-up contribution” limit.
That goes for both traditional and Roth IRAs, and you can split that contribution between the two account types if you prefer. For example, a 35-year-old can contribute $2,000 to their traditional IRA and $4,000 to their Roth IRA if they like. You can split your contributions in any proportions you choose, as long as the sum doesn’t exceed the limit.
Differences Between Traditional & Roth IRAs
IRAs work like brokerage accounts with special benefits. But what are those tax benefits, how do they differ between traditional and Roth IRAs, and what other rules apply differently to each type of IRA?
Taxes: Save Now or Save Later
Since it’s a pretax account, you don’t have to pay taxes on the money you contribute to a traditional IRA. You can deduct these contributions from your taxable income, lowering your income tax liability for the year.
That gives you a tax break this year, but when you retire, you have to pay regular income taxes on withdrawals from your traditional IRA.
Conversely, you still pay taxes this year on money you contribute to Roth IRAs, but you don’t have to pay any income taxes on withdrawals once you retire. Roth IRA contributions are made with after-tax funds — but they grow tax-free and you pay no income tax on your eventual withdrawals in retirement.
Some people prefer the certainty of paying today’s tax rates instead of waiting to see what the future may bring. After all, your taxes could be far higher once you retire.
Required Minimum Distributions
Since 2020, you must start taking withdrawals from your traditional IRA by April 1 of the year after you turn 72 (previously the required age was 70 1/2).
Referred to as required minimum distributions, or RMDs, the amounts of these required withdrawals are calculated annually based on your age and account balance. The IRS requires RMDs as a way to prevent you from permanently shielding your traditional IRA funds from taxes.
They base these distribution calculations on actuarial tables, aiming to force you to empty your IRA around the time you’re statistically likely to kick the bucket. See the IRS worksheets to calculate RMDs to run actual numbers for your IRA.
The IRS does not require RMDs for Roth IRAs, however. You already paid taxes on the contributions, so they have nothing left to collect from you when you take withdrawals. So they don’t care when or if you withdraw funds.
Note that the SECURE Act changed some rules for inherited IRAs, which can affect your estate planning. Talk to a financial advisor before finalizing your estate planning.
Early Withdrawals
If you pull money out of your IRA before reaching age 59 1/2, the IRS generally classifies it as an early withdrawal. That means they hit you with a 10% early withdrawal penalty, plus regular income taxes.
But because you’ve already paid income taxes on your Roth IRA contributions, the rules aren’t quite as restrictive. You can withdraw contributions at any time without additional taxes or the 10% penalty, with some exceptions. You can’t withdraw earnings on those contributions, however. If you contributed $6,000 that has since grown into $6,500, you can withdraw the $6,000 you put in without penalty before you turn 59 1/2, but not the $500 in earnings.
The IRS does provide some exceptions that allow you to withdraw from either IRA early without hitting you with the 10% penalty. Both Roth and traditional IRAs waive the 10% penalty for the following withdrawals:
- To pay for medical insurance premiums after losing your job
- If medical expenses exceed 7.5% of your adjusted gross income
- If you become totally and permanently disabled
- If withdrawn by your beneficiary in the case of your death
- If you incur qualified higher education expenses
- If you use withdrawals to build, buy, or remodel your first home, up to $10,000
- If you’re a qualified reservist
- As part of a series of substantially equal periodic payments, or SEPP plan
In addition, if a Roth account is open and funded for at least five years, and the withdrawal is due to disability, death, or for a down payment on a home purchase, taxes are also waived on the funds withdrawn.
If you worry you may need to withdraw funds from a retirement account before you turn 59 1/2, consider a Roth account because you can withdraw contributions tax-free and penalty-free.
Age Limit on Contributing
You can contribute to a Roth IRA at any age since you pay income taxes on contributions.
But the IRS takes a dimmer view of tax-free contributions to your traditional IRA once you reach 72 and have to start taking RMDs. Unless you’re still working and earning income, you can no longer contribute to your traditional IRA once you turn 72.
Income Limits
High-income earners lose the ability to contribute to an IRA, which phases out at certain income levels. But the income limits differ between traditional and Roth IRAs.
First, note that the income limits for traditional IRA contributions only apply to people with access to an employer-sponsored retirement plan. If you don’t have an employer plan you can contribute to a traditional IRA and deduct that contribution, regardless of your income.
For traditional IRAs, single taxpayers with an employer plan start losing the ability to deduct IRA contributions at a modified adjusted gross income (MAGI) of $66,000 in 2021 ($65,000 for tax year 2020). At an income of $76,000 ($75,000 for tax year 2020), traditional IRA contributions aren’t deductible. Married taxpayers filing jointly start losing the ability to deduct contributions at a combined MAGI of $105,000, and they lose it entirely if they earn over $125,000 ($104,000 and $124,000, respectively, for tax year 2020).
You can still contribute to your traditional IRA, however — the contribution just isn’t deductible. (More on why you might want to do that shortly. )
Different rules apply to Roth IRAs. All taxpayers, including those without an employer retirement plan, lose the ability to contribute to Roth IRAs once they exceed the income limits.
In 2021, those limits start at $125,000 for single taxpayers and phase out until $140,000, above which you can’t contribute to a Roth IRA ($124,000 and $139,000 for tax year 2020). Married couples filing jointly start losing the ability to contribute above a MAGI of $198,000, and they lose it entirely at $208,000 ($196,000 and $206,000 for tax year 2020).
Roth Conversions
You can move and convert funds from your traditional IRA to your Roth IRA if you’d rather pay income taxes now and avoid them later. You can even convert funds when you roll over money from a traditional employer retirement plan such as a 401(k) or SIMPLE IRA to your Roth IRA.
The IRS doesn’t impose an income limit on Roth conversions. High earners can use that fact as a loophole to make “backdoor Roth contributions” by first contributing to a traditional IRA (without taking the deduction), then converting the funds to a Roth IRA.
In other words, even if you earn too much to contribute to a Roth IRA, you can use this loophole to contribute indirectly. But keep in mind that any contributions that you did deduct — and any earnings on them — must be reported as ordinary income during the tax year when you convert them to a Roth IRA.
Should I Contribute to a Roth or Traditional IRA?
First, check your income levels. You may earn too much to contribute to a traditional IRA, but not too much to contribute to your Roth IRA. That makes the decision simple.
If you earn too much to contribute even to a Roth, you can still do a backdoor Roth contribution by contributing to a new traditional IRA, not deducting it, then later converting it to your Roth.
But if you can contribute to either a traditional or Roth IRA, how do you decide which to fund?
Begin by asking yourself if you might need to access the money early, before age 59 1/2. If so, opt for a Roth IRA.
Otherwise, the decision comes down to whether you believe your tax rate will be higher in the future than it is today. Bear in mind that you can split your contributions, putting some money into your traditional IRA and some into your Roth IRA.
Younger workers earning relatively modest income should usually contribute to a Roth IRA. If you’re young and in a lower tax bracket, you don’t pay much in income taxes today, and your Roth IRA has decades to compound tax-free.
As you start earning more, however, the immediate tax deduction you receive for contributing to a traditional IRA starts looking more attractive. If you find yourself slipping over the line into a higher income tax bracket, you could contribute enough to your traditional IRA to avoid paying the higher income tax rate on the overage, while funneling the rest into your Roth IRA.
For example, say you’re married and your combined taxable income is $82,000. Above $80,250, you pay Uncle Sam nearly double the tax rate — 22% rather than 12%. So you could contribute $1,750 to your traditional IRA to avoid paying the higher 22% tax rate on it, while putting the rest of your contributions into your Roth IRA.
In general, if you think you’ll earn more money in retirement than you do today, contribute to your Roth IRA. That applies to most younger workers and some older workers doing laid-back semi-retirement work before they start taking withdrawals.
But during your peak earning years, you could earn more than you will in retirement, and it may make more sense to take the deduction now.
Final Word
When in doubt, contribute to a Roth IRA if you qualify based on your income. You don’t have to worry about future tax rates — which may be higher than today’s rate — and you’ll know exactly what you have to work with when you retire.
Think of it as yet another investment in the future: You swallow the bitter pill of taxes today so you can collect income tax-free tomorrow.
