Most of us know how important it is to save for retirement, but actually putting that knowledge into action can be more of a challenge. According to the National Institute on Retirement Security, four out of five working Americans have less than a single year’s income saved in retirement accounts. (Conventional wisdom suggests you should have 10–12 times your income by the time you’re ready to clock out for the very last time.)
For many Americans, employer-sponsored plans like the 401(k) are the primary vehicle for retirement savings. These programs allow you to automatically defer a certain percentage of each paycheck directly into an investment account, and in most cases you’ll also get a tax break since those wages won’t count toward your taxable income in the year you earn them.
But for those who don’t have access to an employer-sponsored plan, or who simply want to up their retirement savings game by stashing away as much cash as possible, the IRA—or individual retirement account—may be a solution. These accounts allow you to make retirement contributions with special tax benefits, even if you’re self-employed.
Comparing Traditional and Roth IRAs
While all IRAs share certain characteristics in common, they come in different flavors, and it can be confusing to figure out which one you need. The two most common types of IRA the average saver will choose from are the traditional and Roth versions.
The Basics of Both IRA Plans
Traditional and Roth IRAs have certain things in common: They let you save money for retirement and invest it in a variety of ways while potentially taking advantage of tax benefits. You can contribute as long as you’re earning income (or your spouse is), even if you work part-time. And you’re limited to contributing a certain amount each year (in 2019, the ceiling is $6,000 for those under 50).
But they also have important differences, specifically about when and how you might get tax breaks. Your choice can have a big impact on how much money you can keep in your pocket today compared to when you retire. The accounts also differ in who is eligible to contribute and for how long, as well as when you can take distributions.
The good news? You don’t need a crystal ball to get a good sense of which account option is right for you. Keep reading to find out which might fit your lifestyle better.
Am I Eligible for a Traditional IRA or a Roth IRA?
Anyone who gets taxable income can open a traditional IRA, with one exception: You can no longer make regular contributions when you reach the age of 70.5. For a Roth IRA, you can make contributions at any age.
Roth IRAs, however, have a key restriction: You must earn below a certain income limit to be able to contribute. In 2019, that limit was $122,000 for single people (though, if you earn below $137,000, you can contribute a reduced amount). For those who were married and filed taxes jointly, the limit was $193,000 to make a full contribution or $203,000 for a reduced amount.
The ceilings are based on modified adjusted gross income, which is basically the adjusted gross income listed on your tax return with certain deductions added back in.
SoFi’s IRA calculator lets you plug in your income and other factors and could help you figure out which account you can contribute to and how much you can put in.
When Does My IRA Get Taxed?
With a traditional IRA, you can deduct the money you’ve put in (aka your contributions) on your tax return, which lowers your taxable income today. Instead, you will pay income taxes when you withdraw funds in retirement. This is called tax deferral, and it can be a welcome break if you’re at the beginning of your career or earning in a lower tax bracket.
With a Roth IRA, on the other hand, your contributions aren’t tax-deductible today. But you won’t pay any taxes when you withdraw money you’ve contributed at retirement, or when you withdraw earnings if you’re at least 59.5 years old and have had the account for at least five years.
What does this mean for you? You might prefer a traditional IRA if you think you’ll be in a lower tax bracket after you retire. If you think you’ll be in the same tax bracket or a higher one—for example, if you expect to have high earnings from a business, investments, or continued work—you might choose a Roth IRA if you’re eligible.
Can I Withdraw Money From My IRA Before I Retire?
Generally, you might want to leave the money in your IRA untouched so it’s there for you when you’re counting on it. (Plus, the IRS has set up the tax incentives in such a way that it’s usually best to leave them be until you’re ready to retire.)
But if you’re reluctant to contribute to an IRA because you’re afraid your cash will be locked up should you need it, take heart: That’s not always the case.
With a Roth IRA, you can withdraw the money you’ve put in (not counting the money you’ve earned in appreciation) at any time. You can also withdraw up to $10,000 in the earnings you’ve made on investing that money without paying penalties provided you’re using the money to help pay for your first home under certain conditions.
With a traditional IRA, you will generally pay a 10% penalty tax if you take out funds before you’re 59.5. There are some exceptions, including for qualified educational or medical expenses, but in any case, you’ll want to be careful and discuss any potential early withdrawals with a tax professional first.
When Do I Have to Start Taking Money out of My IRA?
With traditional IRAs, you will be subject to required minimum distributions, or RMDs. That means you need to start taking a certain amount of money out of your account (and paying income taxes on it) by April 1 of the year after you reach age 70.5—whether you need the funds or not.
If you don’t take a distribution, the government may charge a 50% penalty on the amount you didn’t withdraw. Taking distributions will add to your income and could put you in a higher tax bracket. If you don’t want to be forced to start withdrawing from your retirement savings, then a Roth IRA may be a better option.
Roth IRAs might also be a vehicle for passing on assets to your heirs or beneficiaries, since you can leave them untouched throughout your life and eventual death if you choose to.
Which IRA Is Right for You?
Let’s review what we’ve learned above.
• Allow all earners to contribute, and you can contribute up to $6,000 per year (or $7,000 per year if you’re making catch-up contributions after age 50).
• Are tax-deferred, meaning you won’t pay taxes on the funds you contribute until you’re ready to take them out in retirement.
• Are subject to a 10% tax penalty on early withdrawals (on top of regular income taxes) unless taken under certain exceptional circumstances, such as medical need.
• Are subject to RMDs starting on April 1 of the year after you reach age 70.5.
• Might be a good option for those who plan to be in a lower tax bracket at retirement, or who need as much of a tax break as possible today.
• Are only available to those who make less than certain prescribed income limits, of $122,000 for single filers or $193,000 for married couples filing jointly in 2019. Eligible savers can still contribute a total of $6,000 per year (or $7,00 per year if you’re making catch-up contributions after age 50).
• Are taxed today, but offer tax-free income at retirement.
• Allow the saver to access the funds they’ve put into the account at any time, and investment earnings up to $10,000 without a tax penalty when purchasing a qualified first home.
• Are not subject to RMDs.
• Might be a good option for those who plan to retire at a higher tax bracket than their current one, who usually get a refund at tax time, or who want the option to pass on their retirement savings easily to heirs or loved ones.
In all cases, an IRA could be a great way to bolster your retirement savings, whether or not you have access to an employer-sponsored plan like a 401(k).
When it comes to retirement, every cent count, and starting as early as possible can make a big difference—so it might be a good idea to figure out which type will work for you sooner than later.
Still confused about whether a traditional or Roth IRA is right for you? A SoFi financial advisor can help you decide. Set up your personalized IRA consultation—at no charge.
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