There are two types of individual retirement accounts (IRAs): Traditional IRAs and Roth IRAs. Often confused, these retirement accounts have distinct similarities and differences which are briefly explained and summarized below based on current law.
Traditional IRAs are retirement vehicles that provide tax-deferred growth. Individuals under the age of 50 may contribute the lesser of earned income or $5,500 in 2017. Individuals who attain the age of 50 before the end of 2017 may contribute an additional catch-up amount of $1,000, making their maximum contribution $6,500 for 2017. Even those who do not have earned income may still establish a traditional IRA if his or her spouse has sufficient earned income. Contributions are not allowed after the of age 70.5.
The deductibility of contributions to a traditional IRA depends on the individual’s active participation status in a company-sponsored retirement plan. An active participant is an employee who has benefited under the following types of plans: 401(k), 403(b), certain government plans, SEP, or SIMPLE. If an employee is not an active participant, the full contribution to a traditional IRA is fully deductible. If an employee is an active participant, income tests exist to determine the deductibility of contributions. Active participants in a retirement plan cannot deduct IRA contributions if filing single with modified adjusted gross income over $72,000 or married filing jointly making over $119,000.
Withdrawals of pre-tax contributions and earnings are taxable when distributed. Withdrawals are penalty-free if you are over the age of 59.5. Once an individual turns 70.5, required minimum distributions (RMDs) must begin by April of the following year or a 50% excise tax is imposed on those RMDs. These distributions are also subject to ordinary income tax. (For related reading, see: Avoiding Mistakes in Required Minimum Distributions.)
Roth IRAs are also retirement vehicles, with contributions being after-tax and growing tax-free. Roth IRAs have the same contribution limits as traditional IRAs. If you have earned income, Roth IRAs also allow contributions after the age of 70.5 while traditional IRAs do not. However, individuals may only contribute to a Roth IRA if their income falls within the prescribed income limits, regardless of whether or not they participate in a company-sponsored retirement plan.
There are two major benefits of utilizing a Roth IRA. Withdrawals from a Roth IRA are both tax-free and penalty-free after age 59.5 (assuming the account has been open for at least five years). Also, there are no RMDs that must be taken during the life of the owner of the IRA. (For related reading, see: How a Roth IRA Works After Retirement.)
Having a mix of taxable and after-tax money in retirement can be beneficial when strategizing efficient portfolio drawdown and managing your tax bracket. For many, it makes sense to contribute to a Roth IRA while they are younger and expect to be in a higher tax bracket later in life.
To determine whether a traditional or Roth IRA is right for you, it is important to speak with a fee-only, certified financial planner. They will help you make the right choice based on your financial situation and your long-term goals.
(For more from this author, see: How to Take Full Advantage of Your 401(k).)