How much should you save for retirement? Is there a limit you can save per year? What plan is the best to follow? Retirement planning can be overwhelming, but it doesn't have to be. We'll help you compare Traditional and Roth IRAs, learn common terminology and give you the tools to decide what’s best for your life after your career. While this article provides a good overview, you should be sure to consult your accountant or tax preparer with specific questions related to your financial decisions.
Words to Know
Before we review the differences and similarities of Traditional and Roth IRAs, here are some terms, along with their definitions, that are helpful to understand.
- Contribution: The assets or funds you deposit into your IRA.
- Distribution: The assets or funds you withdraw from your IRA.
- RMD: Required Minimum Distribution. This is the amount you must withdraw annually from your Traditional IRA once you reach age 70 ½. Your RMD is determined based on your age and other factors.
- Beneficiary: The individual, estate or trust named to receive the assets in your IRA upon your death.
- Compensation: Earned, taxable income. Examples of compensation include W-2 Income wages, tips, salary, bonuses, scholarship/fellowship payments, personal appearance fees; commissions; net earnings from self-employment; taxable alimony; non-taxable combat pay.
Let’s start with the basic difference between the two IRA types. In simple terms, Traditional IRAs receive contributions before taxes are taken out, while Roth IRAs receive contributions after taxes. Because of this, Traditional IRAs defer taxes on earnings until they are withdrawn. Additionally, contributions to Traditional IRAs may be tax deductible within the tax year that they are made.
Roth IRAs, on the other hand, are created using funds that have already been taxed. That means that distributions are non-taxable. In fact, earnings taken as part of a qualified distribution are also tax-free (more on this under Distribution Details).
For an IRA to grow and support you in retirement, the owner has to make contributions. Both Traditional and Roth IRAs are eligible for contributions as long as certain qualifications are met. In both cases, you or your spouse must have some form of compensation (income).
For a Traditional IRA, you must be younger than 70 ½ years in order to make contributions. For the Roth IRA, you must meet the Modified Adjusted Gross Income (MAGI) level for the tax year in question.
How much you contribution annually to your IRA will be the lower of two numbers: 100% of your compensation or the amount specified in the contribution chart issued by the IRS. This number tends to change, so be sure you have current information each year.
You’re ready to withdraw some of your hard-earned and saved money. Now what? If you’re 59 ½, you can make a distribution from a Traditional or Roth IRA at any time.
Keep in mind with Traditional IRAs, there will still be a tax on the distribution. Contributions and any earnings will be taxed in the same year that they occur. Figuring 10% of a distribution amount will typically cover the tax, but you should always check with a tax professional to ensure that you’re withholding the correct amount.
In some cases, you can withdraw funds from your Traditional IRA before you reach age 59 ½ without incurring a penalty. Some examples of situations when that might happen include:
- Having a disability
- Medical expenses in excess of 10% of adjusted gross income
- Distributions paid directly to the IRS due to an IRS levy
- Conversion to a Roth IRA
- Qualified education expenses
- First-time home buyer purchase
- Qualified reservist distribution
Roth IRA distributions of regular contribution amounts are always tax-free, regardless of the reason or timing of the distribution. However, earnings on your assets may be taxed unless they fall within a qualified distribution. Examples of qualified distributions are those that occur after the IRA has been open for more than five years and those that are:
- Made on or after the date you reach age 59 ½
- Made to your beneficiary(ies) after your death
- Made after you meet the IRS definition of becoming disabled
- Used to pay for qualified first-time homebuyer expenses
Roth IRAs never require a distribution. However, a Roth IRA owner can only contribute to the plan if the owner or the owner’s spouse has a form of accepted compensation.
Traditional IRAs can only receive contributions until the owner is age 70 ½. At that time, a Required Minimum Distribution is calculated. The RMD is recalculated on a regular basis and must be taken annually to avoid penalties.
You’ve now seen how Traditional and Roth IRAs compare. If you’re still not sure which one is right for you, here are a few questions – with answers – that might help you decide.
- What happens to my IRA when I die?
- If you named a beneficiary when you set up your IRA, the proceeds of the IRA will go to that person or entity upon your death. This is true whether you have a Traditional or Roth IRA. Distributions from beneficiary IRAs are made based on the original owner’s IRA agreement and RMD rules. They are not subject to the 10% early distribution tax, because they are classified as death distributions.
- Are these the only types of IRAs?
- No, there are also SEP (Simplified Employee Pension) and Simple IRAs. Both of these are typically initiated through an employer. Traditional and Roth IRAs can be opened by an individual, regardless of his/her employer.
- What if I have a retirement plan through my employer? Can I still have an IRA?
- Yes! You can have both an IRA and another plan with your employer (a 401k for example). In fact, you can even have both a Traditional and a Roth IRA at the same time, depending on your financial goals. Consult a tax professional for more details on how to use these financial tools to your advantage.
Dreaming about retirement is one thing. Actually planning for it is the best way to ensure that you can make the most of your days when you no longer have to follow someone else's schedule. The Peoples State Bank can assist you in opening an IRA to plan for your retirement.