Saving for retirement is one of the least exciting personal finance topics, but it is one of the most important. At 62, when persons can start getting social security checks from the government, they will come face to face with all the life decisions they made. According to PWC Retirement Report, almost a quarter of American workers have no retirement savings and only a quarter feel they are prepared for retirement. Persons with no retirement savings is concentrated in the 18-29 age bracket. Personally, I think the reason for this is this age group, my peers, retirement savings is just not a priority. If you’re reading this blog though, clearly you have a different mindset and are ready to put plans in place to ensure you retire without worry. Since you’ve made this decision, the next step is deciding what type of retirement savings account you want to open. The two most popular types of retirement savings account are the Roth IRA and the Traditional IRA. Let’s explore Traditional IRA vs Roth IRA, what these accounts are and the differences between the two.
An individual retirement account (IRA) is a special savings account that individuals open to save and invest long term. These accounts can be opened through your bank, brokerage firm, life insurance company or a mutual fund. The most significant benefit to having a Traditional IRA is its tax deferred characteristics. If you don’t already have a retirement plan with your employer, portions of your income invested in an IRA is tax exempt. That is, you can deduct portions of your contributions from your taxable income. For the tax year 2021, the deductible limit is $6,000. There are income limitations that you should be aware of when considering opening a Traditional IRA. See below income limitation for Traditional IRA deductions:
|If Your Filing Status Is…||And Your Modified AGI Is…||Then You Can Take…|
|Single or||$66,000 or less||Full deduction up to the amount of your contribution limit.|
|Head of Household||More than $66,000 but less than $76,000||Partial deduction.|
|Head of Household||$76,000 or more||No deduction.|
|Married filing jointly or qualifying widow(er)||$105,000 or less||Full deduction up to the amount of your contribution limit.|
|Married filing jointly or qualifying widow(er)||More than $105,000 but less than $125,000||Partial deduction.|
|Married filing jointly or qualifying widow(er)||$125,000 or more||No deduction.|
|Married filing separately||Less than $10,000||A partial deduction.|
|Married filing separately||$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.|
A disadvantage to the Traditional IRA is your distributions upon retirement will be taxed at your marginal income tax rate. This is a disadvantage if your marginal tax rate is higher than what it was when you were making contributions.
Similar to a Traditional IRA, the Roth IRA has tax advantages. With this retirement account, contributions are not deductible, however, qualified distributions are tax free. Many people who opt for this type of retirement account prefer to pay their taxes now, when their marginal tax rate is low, verses later when their marginal tax rate will be higher. Keep in mind, however, that the contribution limit for this account is $6,000 ($7,0000 if 50 or older). Additionally, like the Traditional IRA, there are income limitations that you should be aware of when considering opening a Roth IRA. See the income limitation table below:
|If your filing status is…||And your modified AGI is…||Then you can contribute…|
|Married filing jointly or qualifying widow(er)||< $204,000||Up to the limit|
|Married filing jointly or qualifying widow(er)||> $204,000 but < $214,000||A reduced amount|
|Married filing jointly or qualifying widow(er)||> $214,000||Zero|
|Married filing separately and you lived with your spouse at any time during the year||< $10,000||A reduced amount|
|married filing separately and you lived with your spouse at any time during the year||> $10,000||Zero|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $129,000||Up to the limit|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $129,000 but < $144,000||A reduced amount|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $144,000||Zero|
The key disadvantage to the Roth IRA is your contributions are not tax deductible. Therefore, there is no tax benefit to this account until retire and distributions are made.
Retirement Account Tax Penalties
In an attempt to discourage persons from withdrawing funds from their retirement account, the Internal Revenue Service (IRS) has imposes early withdrawal penalties. While you can withdraw money from a Traditional IRA and a Roth IRA, the funds are subjected to a 10% tax penalty if you are under the age of 59 ½ as of 2021. For the Traditional IRA, those funds are also subjected to income tax.
Which Account Is Better?
Well, depends on what your short-term and long-term objectives are. Some people choose to use the Traditional IRA because of the tax deductions. This lowers your tax liability which is advantageous if you need extra money now. The tax savings could go to your emergency fund, used to pay off debt or to invest in other assets. On the other hand, if you are looking to be strategic about your finances after retirement, a Roth IRA may be the best option for you. If you have other financial accounts where distributions are taxable upon sale/withdrawal, having a Roth IRA means this is additional income will not raise your marginal rate. Thus, will not raise their tax liabilities.
Remember to keep in mind the financial benefits and consequences of each account when deciding if a Traditional IRA or a Roth IRA is best for you. Also keep in mind that there are many other types of retirement savings account that you can look into. The IRS website is a good place to start to learn about each. Don’t forget to check out my other blog posts HERE!
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