Though retirement may seem a lifetime away when you are just starting off in the working world, saving for retirement should always be a priority. In a FINRA survey conducted at the end of 2018, they found that only 58% of the adult workforce held any kind of retirement account (1). For something as important as retirement, 58% is a depressingly low rate of participation. Though you may be anxious to start your retirement savings now, it is a good idea to learn the benefits and tax consequences of the different options available to you. Let’s dive into some of the key similarities and differences of Traditional and Roth IRAs.
Both the Traditional IRA and the Roth IRA:
- Designed to create tax incentives to save for retirement
- Require earned income for each tax year contributions are made
- Subject to a 10% early withdrawal penalty if not a qualified distribution. The 10% withdrawal penalty applies when the account owner is below age 59 ½. Qualified exceptions to the 10% early withdrawal penalty:
- Medical Expenses
- Health Insurance
- Death (Inheritance)
- 72t Payments (Equal and Substantial Periodic Payments)
- Certain Higher Educated Expenses
- First Time Home Purchase
- Certain Veteran/Reservist Distributions
- Differences in the early withdrawal penalty for Roth IRAs:
- Roth IRA contributions can be withdrawn at any time, even before age 59 ½. It is only the Roth IRA earnings that are subject to the early withdrawal penalty.
- To avoid the early withdrawal penalty, the Roth IRA must have been opened for at least 5 years.
- Subject to the same annual contribution limits
- $6,000 if below the age of 50 (2021)
- $7,000 if age 50 or over (2021)
- Contributions made are pre-tax, meaning you get a “tax deduction” for the year in which you made the contribution, bringing down your taxable income. (2) However, if you are covered by an employer-sponsored plan, there are income thresholds for IRA contribution deductibility. This means that over a certain income level, you can still contribute to an IRA, but the contribution will not be deductible from your taxes.
- Once a distribution is taken, the amount is added to your gross income for the year. If taken before the age of 59 1/2, you may be subject to additional penalties.
- Have Required Minimum Distributions (RMDs) at age 72. This is a specific amount that the IRS requires you to take out of your IRA each year to avoid a 50% penalty.
- Any beneficiary of a Traditional IRA will be required to deplete the account within 10 years of inheritance.
- Generally, making Traditional IRA contributions means choosing to pay the taxes on that money in the future (usually in retirement), which makes this typically a better option for someone in a higher tax bracket.
- Contributions made are post-tax monies. In making Roth contributions, you are locking in current tax rates and are able to take tax-free distributions down the road (as long as the qualified distribution requirements are met), meaning you receive no special tax incentive for making contributions.
- Earnings grow tax-free
- No Required Minimum Distributions for the owner. Any beneficiary of a Roth IRA will be required to deplete the account within 5 years of inheritance.
- Flexibility of withdrawing all your contributions without taxes or penalties at any time. Earnings in a Roth IRA are subject to the early withdrawal penalty.
- Qualified distributions are tax free (3)
- Contributions are subject to AGI limits. Some people may not be eligible to contribute. (4)
- Generally, making Roth IRA contributions means paying taxes on that money now, rather than in the future, which makes this typically a better option for someone in a lower tax bracket.
Before deciding which account type to contribute to, make sure this strategy aligns with your financial plan and goals. Reach out to your team of advisors to discuss your options and find the best solution for what meets your individual needs.