IRAs: Advantages, disadvantages and which one is right for you

The individual retirement account (IRA) was created decades ago as defined benefit pension plans were declining. Becoming more popular as workers started to take control of their own retirement savings, the IRA offers individuals an opportunity to save for retirement in a tax-advantaged account.

The traditional and Roth IRA accounts are the most popular types of IRAs. The rules which govern these investments vary. By understanding the  rules for both, you'll be prepared to enjoy the benefits of these investment opportunities.

Tax-Free Growth

Both the Roth and Traditional IRAs offer tax-free growth of assets. This means that once the money is in the account, there are no taxes levied on the dividends or capital gains that the investments earn.

Both also have the same contribution deadline. You are allowed to contribute to your IRA during the entire calendar year and up to April 15 of the following year.

The Roth IRA account contributions are made with after-tax dollars. Traditional IRA contributions are made with pre-tax dollars, which means they can be deducted from your income – in most cases – although there are certain limitations.

Deductions

The deductibility of the IRA accounts are determined by income levels as well as whether you are covered by a workplace retirement account. The IRS explains the IRA deductibility rules for 2018 as follows for those workers who are covered by a workplace retirement account:

If Your Filing Status Is...

And Your Modified AGI Is...

Then You Can Take...

single or
head of household

$63,000 or less

a full deduction up to the amount of your contribution limit

more than $63,000 but less than $73,000

a partial deduction

$73,000 or more

no deduction

married filing jointly or qualifying widow(er)

$101,000 or less

a full deduction up to the amount of your contribution limit

 more than $101,000 but less than $121,000

 a partial deduction

 $121,000 or more

 no deduction

married filing separately

 less than $10,000

 a partial deduction

 $10,000 or more

 no deduction

If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the "single" filing status.

If you’re not covered by a workplace retirement account, the contributions to the IRA are fully deductible (up to the contribution limit) regardless of how much you make, up to $189,000 in AGI (there's a phase-out up to $199,000 for marrieds filing jointly).

Contribution Amounts

IRAs have strict contribution limitations. To contribute to an IRA, you or your spouse need earned income. For 2018, the maximum contribution amount per person is $5,500 or $6,500 if you’re age 50 or older. After you reach age 70½, you can’t contribute to a traditional IRA, although you may still add to the Roth IRA. But if your modified adjusted gross income (MAGI) exceeds a certain level, you may not be able to contribute to a Roth IRA.

Below are the 2018 Roth IRA income requirements:

Filing Status

Modified adjusted gross income (MAGI)

Contribution Limit

Single/Head of Household

< $120,000

$5,500

≥ $120,000 but < $135,000

Partial contribution

≥ $135,000

Not eligible

Married (filing joint returns)

< $189,000

$5,500

≥ $189,000 but < $199,000

Partial contribution

≥ $199,000

Not eligible

Married (filing separately)

Not eligible

$5,500

< $10,000

Partial contribution

≥ $10,000

Not eligible

Notably, if you were married filing separately and you did not live with your spouse at any time during the year, your status counts as single.

Type of Investments

For regular IRAs, you may invest in all sorts of traditional financial assets such as stocks, bonds, ETFs and mutual funds. You can invest in a wider range of investments through a self-directed IRA (one in which you the investor, not a custodian, makes all the investment decisions) – commodities, precious metals, real estate or even peer-to-peer loans. However, no matter what the type of IRA, you may not invest in life insurance or collectibles such as artwork, rugs, antiques, gems and stamps.

Penalties

Since the IRA is intended for retirement, there are often certain penalties if you take out your money before retirement age.

With the traditional IRA, you face a 10% penalty on top of the taxes owed for any withdrawals before age 59½. With the Roth IRA, you can withdraw a sum equal to your contributions penalty- and tax-free at any time; however, you can only withdraw earnings without getting dinged if you’ve held the account for five years and reached age 59½. However, there are a few exceptions to these early withdrawal rules. The most popular include:

  • Withdrawals up to $10,000 to help pay for a first home for yourself, your spouse, children or grandchildren
  • Withdrawals to pay for college expenses for the same

Required Withdrawals

A popular benefit of the Roth IRA is that there is no required withdrawal date. You can actually leave your money in the Roth IRA to let it grow and compound tax-free indefinitely.

There are mandatory withdrawals for your traditional IRA called required minimum distributions (RMD), starting when you reach age 70½. The amount of the withdrawal is calculated based on your life expectancy. There is a 50% penalty, plus taxes owed if you fail to take the RMD. (For more, see "Best Ways to Avoid RMD Tax Hits on IRAs.")

The Bottom Line

The Roth and traditional IRAs are easy to set up with assistance from any discount or standard investment broker. Both have their advantages and disadvantages. Know the rules for what many consider to be stellar retirement vehicles, and check the IRS website for regular changes and updates.