Updated: May 14, 2020
IRA stands for Individual Retirement Account. As you may have guessed, these accounts are for individuals to save for retirement. What you may not know is the unique tax advantages associated with each and some of the various rules that govern these types of accounts. Also, you may be curious which one may be best for you right now.
Let’s find out.
To begin, there are multiple kinds of IRAs, all with distinct advantages, disadvantages, and ideal scenarios where they should be considered. As of 2020, there are four types of IRAs:
IRAs share some common features in how they work and what they are used for. First, they are all tax-advantaged accounts designed for retirement savings. To clarify, IRAs are not investments themselves, they are simply accounts that holds the investments (see IRA – The Sports Car below). Some IRAs are for individual tax-payers while some are for small-business owners and self-employed individuals. There are also income limitations that dictate who can contribute to an IRA and how much. With all IRAs, you (or your spouse) must have earned income in order to contribute. Finally, there are penalties for early withdrawals (with a few exemptions) and requirements for most IRAs to begin distributions by a certain age.
IRA – The Sports Car
Imagine the IRS has created a vehicle, aero-dynamic because of the tax-advantages, beautiful because of its simplicity, and affordable enough for everyone. The only thing is, they only offer the body. It comes in different colors (Traditional Teal, Roth Red, SEP-ia Brown, or SIMPLE White) and each one has slightly different styling cues and features. But none of these cars are going anywhere until you put an engine in them – the investments. After you get the car, you are able to put almost any engine in it you want – stocks, bonds, mutual funds, ETFs, REITs, real estate, and annuities to name a few. Some engines are high octane and might backfire and some are much more reliable, slow and steady.
This post will cover the first two vehicles, Traditional IRAs and Roth IRAs, as these are the two types of IRAs that are most common and accessible to nearly everyone. SEP and SIMPLE IRAs are vehicles designed for small business owners or the self employed and you can learn more about them here (link to SEP vs. SIMPLE post).
Traditional IRAs are generally what people are referring to when they say “IRA.” These vehicles are designed for individuals looking to save for retirement while reducing their tax liability in the current year. Contributions to these accounts are normally tax-deductible, meaning they decrease your taxable income for that year. The maximum that can be contributed in 2020 is $6,000 (contributions are not to be confused with rollovers, transfers, or conversions – a future post will cover these items). Additionally, if you are 50 or older, you can contribute an extra $1,000 called a “catch-up contribution.”
*Pro Tip* Did you know that you could be eligible for a tax credit just for contributing to a retirement account, like an IRA? If you are 18 or older, not a full-time student, and not claimed as a dependent, you could be eligible for a tax credit up to $2,000! It’s called the Saver’s Credit, Google it!
As I mentioned before, contributions are normally tax-deductible. Anyone, of any age, can contribute to an IRA as long as they (or their spouse) have earned income in that calendar year that falls within the following parameters:
If you do not have a retirement plan offered at work, you can make fully tax-deductible contributions to your IRA, no matter how much you earn.
If you have a retirement plan at work (401(k), 403(b), etc.) AND make more than $65,000 (single) or $104,000 (married), then you can only deduct a portion of your contribution.
If you make more than $75,000 (single) or $124,000 (married) with a retirement plan at work, you cannot deduct ANY of your contribution.
*Pro Tip* If you are phased out of deducting your IRA contribution, you can still make a non-deductible contribution to your IRA and take advantage of tax-deferral.
Any dollars invested in your IRA will grow tax deferred, meaning you will not owe any taxes UNTIL you go to withdraw money in retirement. Beginning at age 59 ½ you can take money out without penalty, but you will be liable for ordinary income tax on every dollar withdrawn. (This is because you did not pay taxes on it when initially invested in the IRA). If you were to take money out prior to 59 ½, you would owe an additional 10% penalty on your withdrawal on top of the ordinary income tax. (There are a few circumstances that would avoid this early withdrawal penalty, like the payment of insurance premiums after losing a job).
Once you reach age 72, the IRS requires that you start taking distributions. These are known as required minimum distributions (RMDs). They are calculated as a percentage of your account balance that must be distributed, thus prompting you to begin paying income tax on those tax deferred dollars. Uncle Sam wants his cut!
Traditional IRA In A Nutshell – Aside from a few caveats, dollars going into an IRA are not taxed, they grow tax deferred, and are fully taxed when used in retirement. These are best for individuals who want to save for retirement and are looking for a way to reduce their current tax bill but may not have access to a retirement plan at work.
Roth IRAs, often referred to as simply Roths, work in the exact opposite fashion from Traditional IRAs. Contributions to a Roth are NOT tax-deductible, meaning it will be “after-tax” dollars going in. If you are thinking, well that’s a bummer, why would I ever use one of those? Well I’m so glad you asked, it is because these Roth dollars WILL NEVER BE TAXED AGAIN. Just like with Traditional IRAs, anyone can contribute to a Roth as long as they (or their spouse) have earned income in that calendar year. Also, just like Traditional IRAs, the contribution limits are $6,000/year in 2020 with a $1,000 catch-up contribution for individuals 50 and over.
*Pro Tip* The contribution limitations of Traditional and Roth IRAs are SHARED between all of your Traditional and Roth IRAs. Therefore, if you contribute $3,000 to your Roth, you would only be able to contribute $3,000 to your Traditional IRA in that year, equaling a total of $6,000 for the year.
The income restrictions are a bit different, however. No matter if you have a retirement plan at work or not, you can fully contribute to a Roth as long as your income is below $124,000 (single) or $196,000 (married). Once income reaches $139,000 (single) or $206,000 (married), then you can no longer make any Roth IRA contributions for that year.
Withdrawals are permitted without penalty (and of course without income tax) at 59 ½. One of the best parts of a Roth is that there are no RMDs at age 72! This is because you already paid your taxes on the front end, so Uncle Sam doesn’t care if/when you take the money out on the back end.
Another unique feature about Roths is that you are able to take out whatever you have put in (the principal), completely penalty free, after the funds have been in the account for 5 years. There are also the same hardship early withdrawal options as the Traditional IRA.
*Pro Tip* It is rarely in your best interest to take dollars out of a Roth IRA early unless it is truly an emergency because once taken out, there is no way to get these dollars back in after 60 days have passed. Make sure to talk to your financial advisor and/or accountant prior to taking early withdrawals from you Roth.
Roth IRA In A Nutshell – Roth IRA contributions are always after tax but then those dollars are NEVER taxed again. Roths are ideal vehicles for individuals that want to save for retirement, are not concerned about reducing their current tax bill, and would like tax-free income in retirement.
Planting Trees – Traditional IRA vs. Roth IRA
Now imagine you are planting trees in an orchard. The owner offers you the option of how you would like to pay for the use of the orchard. This orchard specializes in trees that take 30 years to mature and begin producing fruit.
Option A – The orchard owner will give you the seeds for free, you can take care of them however you would like at no charge for 30 years, but once the full grown trees begin to produce fruit, he is going to take ¼ of every fruit on the tree before you can use it for as long as you live.
Option B – The orchard owner wants 25% of all of your seeds before you can plant your trees. Then, for the next 30 years, you can take care of the trees however you would like free of charge. Once the trees are mature, you would be able to use 100% of the fruit without paying anything to the orchard owner ever again.
Therefore, you must decide, do you want to pay the orchard owner on the fruit or the seeds? This is the Traditional vs. Roth IRA decision.
Traditional vs. Roth IRA Comparison
IRAs are wonderful vehicles for retirement savings. Each one has its own benefits and limitations. But tax deferred growth is something that should not be taken lightly! Just make sure you give thought to if you would like to pay tax on the seed or the fruit, and pay particular attention to what type of engine you put in your new sports car!
This information has been provided for general educational purposes only; it has been obtained for sources deemed to be reliable, but we cannot guarantee that it is accurate or complete. The information provided is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. All investing involves some degree of risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Every investor’s situation is unique, you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with a financial professional about your individual situation. Raymond James Financial Services, Inc. and its advisors do not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional.