Traditional and Roth IRA plans are used to secure funds for retirement. They have similarities and differences, mainly in their contribution and distribution rules. Generally, the account best for you in retirement depends on your specific tax situation.
What is Common between the IRA accounts?
ira earnings grow tax-free
A significant advantage is that earnings grow tax-free. You can save all your retirement money or supplement funds if you have other retirement accounts without worrying about paying taxes as your money grows in the account.
Must have taxable compensation
To contribute, you must have taxable compensation, which includes wages, salary, tips, commissions or bonuses, professional fees, or net earnings from self-employment. Other payments like alimony and child support are eligible income. If you are married, you can open a spousal IRA if one of the spouses has taxable compensation. In this case, both spouses can contribute to their accounts.
Contribution limits and deadline to make contributions
2022 contribution limits are the lesser of $6,000 ($7,000 if 50 or older) or taxable compensation. The limit does not apply to rollover contributions and qualified reservist repayments (for military reservists). Also, the deadline to make contributions is the filing deadline, April 18, 2023 (not including extensions).
Moreover, the IRS charges a 6% penalty if you exceed the contribution limit. To avoid the penalty, you must withdraw the excess contributions by the due date of your individual tax return (including extensions).
IMPORTANT: However, if you have more than one IRA, your total contributions to all accounts cannot exceed $6,000 ($7,000 if 50 or older).
Example:
If you are 35 years old with two traditional IRA accounts, you can only contribute $3,000 to each account ($6,000 total). If you are 50 or older, you can contribute $3,500 to each account ($7,000 total).
10% penalty for early withdrawals
If you withdraw before 59.5, you must pay a 10% penalty unless an exception applies to you. Visit the IRS.gov website to see the list of exceptions.
What is different between the IRA accounts?
deductibility of contributions
Traditional IRA contributions are deductible, but Roth contributions are not. Deductions may be limited if you or your spouse has a retirement plan at work. If you or your spouse has a retirement plan at work, visit the IRS.gov website to see if you are allowed a full, partial, or no deduction.
Taxability of distributions
Traditional IRA distributions are generally taxable at your tax rate. For Roth IRAs, you can withdraw original contributions tax-free and penalty-free at any age. However, if you withdraw earnings (investment income) from your Roth IRA, you must be at least 59.5 and meet the five-year rule (the account must be open for at least five years) to avoid taxes and a 10% penalty. If you withdraw before 59.5 and do not meet the five-year rule, you can only avoid the 10% penalty by meeting one of the IRS’s exceptions. If you withdraw before 59.5 and meet the five-year rule, you can avoid both taxes and the 10% penalty by meeting one of the IRS’s exceptions.
Visit the IRS website to learn about the exceptions.
Required minimum distributions
For traditional IRAs, you must take required minimum distributions (RMDs). You must take your first RMD by April 1, following the year you turn 72 (70.5 if you reached 70.5 before January 1, 2020). In subsequent years, you must take your RMDs by December 31. Roth IRAs do not have RMDs if you are the original owner.
Income limits for roth ira contributions
There are modified adjusted gross income (MAGI) thresholds that you must meet to contribute to a Roth account.
You can contribute up to $6,000 ($7,000 if 50 or older) if your filing status and MAGI are:
- Single, head of household, or married filing separately (spouses did not live together): under $129,000
- Married filing jointly or qualifying widow(er)s: under $204,000
Considerations when selecting an ira
Generally, if you think you will be in a higher tax bracket in retirement, a Roth IRA may be better as you will pay lower taxes now and take tax-free distributions when you have higher income. If you think you will be in a lower tax bracket in retirement, a traditional IRA may be more beneficial as you will pay lower taxes on the distributions you take than now.
Do you not meet the income thresholds for a Roth IRA? A backdoor Roth IRA might be for you. Learn more about backdoor Roth IRAs.
