IRA Accounts: Traditional and Roth
Updated on Oct 15 2019
Individual retirement accounts (IRAs) are one of the best resources for retirement planning and savings as they offer tax advantages and catch-up contributions. While they may seem complicated, the basics are easier to understand than you may think.
What is an IRA?
An IRA is a type of investment or savings account that comes with tax benefits to help you save for your retirement. An IRA is an ideal option to grow a nest egg over time as the money you invest young can compound and be worth 10 times what you owe, depending on when you start financial planning and investing.
Not everyone gets to take advantage of IRAs as there are eligibility restrictions based on your income or employment status. There are also caps on how much you can contribute each year and penalties for withdrawing money before the designated retirement age.
What are the different types of IRAs?
There are three types of IRAs that offer additional benefits:
- Roth – A Roth IRA offers a tax deduction for the tax year in which the contribution was made. You fund the account with post-tax income so that all future withdrawals that follow the Roth IRA regulations are tax free.
Roth IRAs make the most sense if you expect your tax rate to be higher during retirement than your current rate. Roth IRAs are typically ideal savings vehicles for young, lower-income workers who won’t miss the upfront tax deduction and will benefit from decades of tax-free compounded growth.
Eligibility – In order to enroll in a Roth IRA, you need to have a median household income of about $50,000.
Maximum Contribution – You can contribute the maximum $5,500 to a Roth IRA a year ($6,500 if you are age 50 or older by the end of the year) if you are the single head of household and your modified adjusted gross income (MAGI) is less than $118,000.
Partial Contribution – At higher income levels you can contribute less, based on a formula devised by the IRS. You must meet these income requirements:
- You are single and your MAGI is between $118,000 and $133,000.
- You are married filing jointly and your MAGI is between $183,000 and $193,000.
*You can’t contribute to a Roth IRA if your income is above those pay scales.
- Traditional – A traditional IRA lets your earnings grow tax-deferred. You pay taxes on your investment gains only when you make withdrawals in retirement.
Eligibility – There’s no maximum income limit for a traditional IRA. You can invest in a traditional IRA no matter how much money you earn. You can’t make contributions after age 70½, though.
Maximum Contribution – You can contribute the maximum $5,500 to a Roth IRA a year ($6,500 if you are age 50 or older by the end of the year).
Tax-deductible Contributions – If you don’t have a retirement plan at work, you can deduct the entire amount of your IRA contribution up to $5,500 annually ($6,500 if you’re 50 or older)
When should you start contributing to an IRA?
You should start contributing to your IRA as early as possible to reap the rewards of growing your money exponentially over time. Even if you’re approaching retirement, though, you can take advantage of the tax benefits and investment opportunity that IRAs offer. For example, there are catch-up contributions geared specifically for seniors over age 50 years.
Can I contribute to an IRA if I participate in a retirement plan at work?
You can contribute to a traditional or Roth IRA whether or not you participate in another retirement plan through your employer or business. However, you might not be able to deduct all of your traditional IRA contributions if you or your spouse participates in another retirement plan at work. Roth IRA contributions might be limited if your income exceeds a certain level.
Where do you get an IRA?
IRAs can be opened at most financial services providers, online or in person. That includes local banks and credit unions, brokerage firms and big mutual fund superstores or discount brokerages. You can find a local financial advisor to help you set up an IRA account. Though there are advantages and disadvantages to service providers, new savers should look for ample resources made available to investors, such as online educational materials and in-person guidance.
What questions should I ask potential providers about IRAs?
It’s important to find a provider or financial advisor you trust. Here are a few questions to ask to ensure you’re getting someone who is qualified and is not overcharging you for services:
- What are the fees or how much does the service cost?
- What kind of guidance or advice can you offer?
- How are you paid?
- What types of investments can be held in the account?
- What are the trading costs?
Are their IRA program tips for high-earners?
High income earners can pay half their income at the margin in taxes, which is why it’s never been so important to shield as much income as possible from taxes. Tax advantage retirement accounts can help, but they have their limits.
Deductible IRA contributions and Roth IRA accounts are out of the question with higher incomes, however partial contributions are available to some—depending on your income. Another possible option for the affluent is the backdoor Roth IRA.
What is the Backdoor Roth IRA?
A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA into a Roth IRA. Contributing directly to a Roth IRA is restricted if your income is beyond certain limits, but there are no income limits for conversions and you can receive significant tax benefits by converting to a Roth IRA.
As with any investment and retirement savings, a wealth manager or investment advisor can help you determine what makes sense for your unique situation.
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