What Is a Traditional IRA?

Traditional individual retirement accounts (IRAs) can be a good way to save for retirement. If you do not participate in an employer-sponsored retirement plan or would like to supplement that plan, a traditional IRA could work for you.

A traditional IRA is simply a tax-deferred savings account that has several investing options and is set up through an investment institution. For instance, an IRA can include stocks, bonds, mutual funds, cash equivalents, real estate, and other investment vehicles.

One of the benefits of a traditional IRA is the potential for tax-deductible contributions. You may be eligible to make a tax-deductible contribution of up to $6,000 ($7,000 if you are 50 or older) in 2019 and 2020. Contribution limits are indexed annually for inflation.

You can contribute directly to a traditional IRA or you can transfer assets directly from another type of qualified plan, such as a SEP or a SIMPLE IRA. Rollovers may also be made from a qualified employer-sponsored plan, such as a 401(k) or 403(b), after you change jobs or retire. (Make sure you understand the pros and cons of rolling funds from an employer plan to an IRA, including leaving the funds in your employer plan if the plan allows it, before you take any action.)

Not everyone contributing to a traditional IRA is eligible for a tax deduction. If you are an active participant in a qualified workplace retirement plan — such as a 401(k) or a simplified employee pension plan — your IRA deduction may be reduced or eliminated, based on your income.

In 2020, for example, if your modified adjusted gross income (AGI) is $65,000 (up from $64,000 in 2019) or less as a single filer or $104,000 or less for married couples filing jointly (up from $103,000 in 2019), you can receive the full tax deduction. On the other hand, if your AGI is more than $75,000 (up from $74,000 in 2019) as a single filer or $124,000 for married couples filing jointly (up from $123,000 in 2019), you are not eligible for a tax deduction. Partial deductions are allowed for single filers whose incomes are between $65,000 and $75,000 (up from $64,000 and $74,000 in 2019) or between $104,000 and $124,000 (up from $103,000 and $123,000 in 2019) for married couples filing jointly. If you are not an active participant in an employer-sponsored retirement plan, you are eligible for a full tax deduction.

Nondeductible contributions may necessitate some very complicated paperwork when you begin withdrawals from your account. If your contributions are not tax deductible, you may be better served by another retirement plan, such as a Roth IRA. (The maximum combined annual contribution an individual can make to traditional and Roth IRAs is $6,000 in 2020 (unchanged from 2019.)

The funds in a traditional IRA accumulate tax deferred, which means you do not have to pay taxes until you start receiving distributions in retirement, a time when you might be in a lower tax bracket. Withdrawals are taxed as ordinary income. Withdrawals taken prior to age 59½ may also be subject to a 10% federal income tax penalty. Exceptions to this early-withdrawal penalty include distributions resulting from disability, unemployment, and qualified first-time home expenses ($10,000 lifetime limit), as well as distributions used to pay higher-education expenses.

You must begin taking annual required minimum distributions (RMDs) from a traditional IRA after you turn 72 (starting no later than April 1 of the year after the year you reach 72), or you will be subject to a 50% income tax penalty on the amount that should have been withdrawn. Of course, you can always withdraw more than the required minimum amount or even withdraw the entire balance as a lump sum.

An IRA can be a valuable addition to your retirement and tax management efforts. By working with a financial professional, you can determine whether a traditional IRA would be appropriate for you.

What Is a Roth IRA?

Roth IRAs are tax-favored financial vehicles that enable investors to save money for retirement. They differ from traditional IRAs in that taxpayers cannot deduct contributions made to a Roth. However, qualified Roth IRA distributions in retirement are free of federal income tax and aren’t included in a taxpayer’s gross income. That can be advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.

A Roth IRA is subject to the same contribution limits as a traditional IRA, the maximum combined annual contribution an individual can make to traditional and Roth IRAs is $6,000 in 2020, the same as in 2019. Special “catch-up” contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits.

Roth IRA owners can contribute to a Roth after age 72 as long as they have earned income, and they don’t have to begin taking mandatory distributions due to age, as they do with traditional IRAs; however, beneficiaries of Roth IRAs must take mandatory distributions.

Roth IRA withdrawals of contributions can be made at any time and for any reason. Withdrawals of contributions are tax-free and not subject to the 10% federal income tax penalty for early withdrawals. In order to make a qualified tax-free and penalty-free distribution of earnings, the account must meet the five-year holding requirement and the account holder must be age 59½ or older. Otherwise, these withdrawals of earnings are subject to ordinary income tax and the 10% federal income tax penalty (with certain exceptions including death, disability, unreimbursed medical expenses in excess of 10% of adjusted gross income, higher-education expenses the purchase of a first home ($10,000 lifetime cap) substantially equal periodic payments, and qualified reservist distributions).

Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to make annual contributions to a Roth IRA phases out for taxpayers with higher incomes.

If you’re looking for a retirement savings vehicle with some distinct tax advantages, the Roth IRA could be appropriate for you.