Money Girl cuts through the confusion and explains the pros and cons of IRAs and how to know if a traditional or Roth account is best for you.

25 minute read

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Hey everyone. Welcome back to the money girl podcast. I’m Laura Adams, uh, leading personal finance and small business expert. And award-winning author. I’ve been writing and hosting this show since 2008, and I am so

Grateful and honored that you keep tuning in week after week, downloading the show and making it a part of your, your life, your education and your routine, wherever you are in the world. I love connecting with you and serving you here. So again, thank you so much for subscribing downloading the show, sharing it with your friends, writing reviews and all that good stuff. This show is all about delivering financial education tips and advice that I hope will be inspiring. And maybe even a little entertaining if you don’t know how money works or the exact next steps to take in your financial life, I’m convinced that it can be impossible to make the right decisions and improve your finances. And I think that listening to other people’s questions can be a really great way to learn. So I’m starting to incorporate a few of your questions in each show, kind of starting out that way and then moving into the topics.

So I hope that will give you a little more exposure to some of the things that other people are asking. And of course, I love to get your question as well. So let’s start out with today’s questions. The first one is from Jamie B, who says I have a young daughter just starting her career. She needs a quick reference guide on how to invest for retirement. I recall you mentioning that you have a PDF guide that captures the major pros and cons of common retirement accounts. How can I share that with her? Jamie, thank you so much for asking that resource is called the retirement account comparison chart and the easiest way to get it is for you or your daughter to send a text message, text the word retire, R E T I R E to the number 3, 3, 4, 4, 4. And you can instantly download it.

It’s a one page, you know, pretty handy resource. And I know the comparison chart would also be really helpful for today’s show. So if you are in a place right now where you could download the guide and review it, this will help because today’s episode number 688 is called, should you have a traditional or Roth IRA? So we’re going to be going back and forth between these accounts and think having the resource in front of you could be helpful. I also got an email from em, who says I currently max out all my retirement accounts and my husband and I will likely make too much to contribute to our Roth IRAs due to unforeseen bonuses and commissions. Thanks by the way, for podcast 6 61, where you explain how to correct an IRA overage as we’ll be needing to do that this year. Here’s my question.

My husband has a simple IRA and I have a traditional IRA. Is there any reason not to transfer these accounts into our current 401k plans if they take rollovers? So we can both do backdoor Roth IRAs. I know we can contribute to Roth 401ks at work, but we enjoy the tax break. We get from making pre-tax contributions to our traditional 401ks, but maybe I’ll consider splitting my contribution between a traditional and a Roth 401k 50 50. I love your short tidbits of just the right amount of information in the right amount of time, perfectly delivered. Thank you so much for your kind words. Am I really appreciate that and congrats to you and your husband for being amazing savers and prioritizing your retirement accounts. I’m going to give you a virtual high five right now. It really makes me happy to know that you’re doing all the right things.

And at this point you’re really just tweaking your success a bit. Now, this is a pretty advanced question. So stick with me here. If you’re not sure what our backdoor Roth IRA is or any of the topics that Ann brought up. And if my answer confuses you, be sure to listen to the rest of the podcast for clarity. And there is no downside to rolling over your traditional IRAs into your 401ks. If they allow it. As you mentioned, this is a strategy that I discussed recently in podcast number 666 called what is a backdoor Roth IRA. So be sure to check out that show if you want more information, but here’s the deal. In a nutshell, the back door method is how you can have a Roth IRA. Even if you technically don’t qualify for one due to your income being too high. That’s an awesome problem to have.

Right? First you make a non-deductible, which is a taxable contribution to a traditional IRA. And then you roll over those funds into a Roth IRA. You won’t owe taxes except on any investment growth in the account earned between the time of your traditional IRA contribution and the Roth conversion. Again, a lot more information about this in podcast 666, but if you already have pre tax money in a traditional IRA, like em does tax has to be prorated over all your IRAs, which doesn’t allow you to avoid additional tax. However, by rolling over your traditional IRA funds into your traditional 401k at work that does not trigger any taxes and it gets around this problem of having existing IRA funds so that you won’t have any traditional IRA funds. Yeah, this gets a little tricky. So always get help from your retirement fund administrator. If you think you might benefit from doing a backdoor Roth IRA, and again, it’s only going to apply to you if your income is too high to contribute to a Roth IRA, we’re going to go over.

What that limit is in the show. M also mentioned splitting her 401k contributions, 50 50 at work. And I love that there’s no income limit on a Roth at work on a Roth 401k or Roth 4 0 3 B. So she can max one out every year or even make a partial contribution, no matter your income. And that’s a great idea because having some amount of tax-free income to count on in retirement is a smart move. So, em, and Jamie, thank you for your questions. I hope that helped. So now let’s get into today’s topic, which is, should you have a traditional or a Roth IRA? This is a pretty foundational finance topic and I’ve podcasted about it before, but I think it’s worth revisiting not only because various annual limits have changed, but because the difference between these accounts can get confusing. It trips up a lot of people.

And unfortunately I found that many people have questions about retirement accounts that keep them from getting one up and keeps them from accumulating wealth for the future. I know that was the case for me when I was in my twenties and I was just starting out with my first real job. My employer kept talking about participating in a 401k and I had absolutely no idea what they were talking about. I kept thinking of that cereal special K, and it sounded like something that had nothing to do with my job. I often say that a confused mind always says no. So that was me. I was confused. And I said, no, and I did not participate until a year or two later when I moved on to a new job that did a great job explaining the benefits of a workplace retirement account. And they paid free matching funds.

So that’s when it clicked for me, it was like, okay, I get it now. And I never looked back, but maybe you don’t have a retirement plan at work or you’re self-employed and you’re just not sure how IRAs work or you’re not sure about the traditional versus Roth benefits that uncertainty could be the barrier that is stopping you from moving forward and taking control of your finances. So my goal for this show is to clear up any confusion. You’re going to learn the main differences between accounts and how to know if a traditional or a Roth is best for you. And I’ll give you some tips for investing your IRA contributions wisely, no matter which one you choose. The bottom line is that if you plan to have a financially comfortable retirement, there is no getting around the fact that you should be using one or more tax advantage retirement accounts.

And I’m a big fan of the individual retirement account or IRA because it’s available to anyone with some amount of earned income. No matter if you’re a teenager who has a job, you’re a retiree, who’s got part-time income. You may be work for a small company that doesn’t have a retirement plan or you’re, self-employed all of those people can have an IRA. So let’s start out with kind of the basics. What is an IRA? And I think it’s important to start out with kind of a fundamental concept, which is an IRA in itself is not an investment. An IRA is just an account where you put your investments. So it’s kind of like your house or apartment it shelters and protects you, but it’s not you in a similar way, an IRA or any retirement account for that matter. It’s just a shelter that protects your investments from taxation while you own them inside the account and different accounts, give different tax benefits, which we’re going to cover.

And you can put just about any investment in an IRA. It could be stocks, stock funds, bonds, bond funds, exchange, traded funds, mutual funds, index funds, CDs, money market funds. And if you open a self-directed IRA, you can even own less mainstream investments in an IRA such as real estate or even businesses, but we’re just going to focus on traditional and Roth IRAs here. So let’s cover a traditional IRA first, and then we’ll get to the Roth. As I mentioned, a traditional IRA is available to anyone with earned income. That includes wages, salaries, commissions, taxable, alimony, and self-employment income. And for the purposes of an IRA, some types of income are excluded. So for an IRA, you cannot count any earnings or profit from real estate or interest, income, or pension or annuity income for the purposes of an IRA. They don’t count as earned income.

Note that before January 1st, 2020, you had to be under age 70 and a half to qualify to make contributions to a traditional IRA. But that is no longer the rule. This is pretty cool. You can continue making contributions to a traditional IRA, as long as you’ve got the earned income that I just mentioned. Another critical point is that if you don’t earned income, but you are married and your spouse does have earned income, you can qualify for what’s called a spousal IRA. It’s not really a different type of IRA. It simply means that you can use your spouse’s income to contribute to your IRA. For 2021, you can contribute an amount equal to your or your spouse’s earned income up to $6,000. However, if you’re over age 50, you can make an additional annual catch-up contribution of 1000 for a total of $7,000. Now let’s talk about the primary benefits of owning investments in a traditional IRA.

It really comes down to the fact that you do not pay tax on the money that you put in the account. In other words, your contributions are tax deductible. However, your future withdrawals of the contributions and the earnings in the account, that’s when you pay tax, they are subject to your ordinary income tax rate at that time. So let’s say you’re 35 years old, you’re earning $35,000 and you filed taxes as a single person. If you max out your traditional IRA by contributing $6,000 in 2021, you only pay tax on $29,000 of income, not on 35,000, your $6,000. IRA contribution would give you a tax savings of about $720. So every dollar that you contribute to a traditional IRA reduces your taxable income and that cuts your taxes and saves you money. Now, one rule to know is that if you or a spouse participate in a retirement plan at work, you can still max out a traditional IRA.

However, some or all of your contributions may not be tax deductible depending on your income. So if you’re a high earner, it may be the case that you can max out that traditional IRA and your retirement plan at, at work. But it may mean that you just can’t get the full tax deduction on your traditional IRA contributions, but they’re still going to grow in the account, you know, on a, on a tax deferred basis. So, you know, it’s still a good idea as your IRA investments grow in value. You are never taxed on those earnings until you take them out of the account in retirement, or even before retirement. If you qualify for an exemption. Now, if you own those same investments in a regular taxable brokerage account, you would have to pay tax on your investment gains every single year. You don’t have to do that when they’re in a traditional IRA, because that’s the protection, that’s the tax shelter that you’re getting.

So a traditional IRA allows you to defer paying taxes. You don’t eliminate it. You just defer it for both your contributions and your earnings until you withdraw money in the future. And you can begin making distributions penalty free. Once you reach the official retirement age of 59 and a half, and you must start taking required minimum distributions or RMDs after age 72, if you tap a traditional IRA before reaching age 59 and a half, in most cases, you must pay income taxes on the withdrawal, plus an additional 10% early withdrawal penalty. So that’s why I never recommend breaking open your retirement piggy bank. It’s just too expensive. You want to put the money in and leave it alone.

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All right, now let’s switch gears and cover the Roth IRA. Unlike the traditional or Roth is only available when you earn less than an annual threshold, and I’m going to give you the details on that limit in just a moment for 2021, the amount you can contribute to a Roth IRA is the same as what we covered for a traditional IRA. You can put in an amount equal to your earned income up to $6,000 or 7,000. If you’re over age 50, like with a traditional IRA, you can make Roth IRA contributions, no matter your age, if you’ve got qualifying earned income and a Roth IRA is similar to a traditional IRA in many ways, except that it comes with very different tax benefits. While the money you put into a Roth IRA is not tax deductible. Your withdrawals are entirely tax-free. So let me go back to my previous example where you’re 35 years old, you earn $35,000 and you contribute $6,000 to a Roth IRA.

In this case, you would have to pay tax on your total earnings of $35,000. The money you put in is not getting any tax benefit upfront, but the feature of a Roth IRA is that you will never owe another penny in taxes, not even on the potentially massive amount of account growth that can accumulate over decades, having that tax-free investment growth and that tax-free retirement income is a huge deal. Additionally, there’s new rule that you have to take RMDs or required minimum distributions starting at age 72. As you do with a traditional IRA with a Roth IRA, your money can just like sit there forever. If you like. And that means you can easily pass it on to your heirs. If you don’t need to spend the money. The last significant benefit of having a Roth IRA that I want to mention is that it is the most flexible type of retirement account.

When it comes to taking money out. Since you’ve got to pay tax upfront on your contributions, you get to take them out at any time. Again, that’s not something that I recommend. I recommend putting the money in and leaving it. But if you think that you might need to take that money out for, I don’t know, paying for kids’ college or going to school yourself that is possible with a Roth IRA. Again, since you pay the tax upfront on your contributions, you can take them as distributions at any time, even if you’re younger than age, 59 and a half, you get to tap them penalty free. However, there are different rules for the earnings portion of a Roth IRA because remembered that the earnings that growth in the account, you have not paid tax on yet. So believe me, the government’s going to get their share.

So once you’ve owned the account for five years and you reach age 59 and a half, that’s when you also qualify to withdraw the earnings portion penalty free. But if you withdraw them, when you’re younger than age 59 and a half investment earnings, you take out will be subject to income tax plus an additional 10% penalty. So again, it’s just on the earnings portion, which, you know, depending on the growth you’ve seen in the account could be small, or it could be significant. Be aware of that. The Roth IRA has a five year rule that supersedes reaching the retirement age. So in other words, even if you’re over age 59 and a half, if you have not owned the account for at least five years, the earnings portion of your distribution would be taxable. However, once the five-year waiting period is up, you’re in the clear and you can make entirely tax-free Roth, IRA distributions.

So to avoid violating that Roth five-year rule, it’s really smart to make sure that you have a Roth IRA open sooner, rather than later, that ensures that you’ll never be in a situation where you do have to pay some amount of tax on a Roth distribution. So if you qualify for a Roth IRA, go ahead and get one opened up. Now, even if you only, you know, can contribute a small amount. So I mentioned that you cannot have a Roth IRA when you’re a high earner. The upper income limit depends on your tax filing status and your modified, adjusted gross income. So here are the top income thresholds to qualify for a Roth IRA in 2021. If you are a single taxpayer, you have to earn less than $140,000. Again, that’s your modified, adjusted gross income.

Married taxpayers who filed jointly must earn less than 200, $8,000 as a household. So that’s the upper limit. If you’re married and you file taxes jointly. Now let’s say you qualify to contribute to a Roth IRA now, but later on, your income goes up and it’s too high to qualify. Well, the first thing to do is pat yourself on the back and say, congratulations, it’s no problem because you can keep your Roth IRA open, indefinitely, and enjoy that tax-free growth. However, you won’t be allowed to make any new contributions unless your income dips below the annual limit in any given year, if you’re eligible to contribute to either a traditional or a Roth IRA, you know, the big question that many people ask is, well, you know, what should I choose? What’s right for me? Let me summarize the advantages and disadvantages of each one.

So you can think about what’s best for your situation. So here are the main advantages of a traditional IRA, paying less tax. Again, your contributions, reduce your taxable income for the year, unless you are a spouse, have a retirement plan at work and earn over an annual income limit. And I’ll put a link in the show notes in the money girl section@quickanddirtytips.com. So you can find out more about the income limits that apply when you’ve got a retirement plan at work and an IRA. Another benefit is deferring tax. If you believe that your income or your tax rate in retirement will be lower than it is now deferring tax until you make withdrawals could be a very wise move. For instance, let’s say you’re middle-aged or you know that your career earnings have peaked. A traditional IRA may save you money on taxes. Another benefit is timing your future tax.

You can begin taking penalty free withdrawals, and of course, pay tax on them. Starting at age 59 and a half. You get to avoid potential additional taxation. Since you only pay tax on traditional IRA withdrawals, that may give you peace of mind that your retirement funds could never be taxed twice in or in other words, tax now, upfront and later on in retirement, it’s not likely that double taxation on retirement accounts could ever pass legislation, but that’s something that some people worry about with a Roth IRA. In other words, they’re thinking, okay, what if I pay tax now? And then later in retirement, the government makes me pay tax again. I don’t think that’s an issue, but again, some people worry about it. So now let’s consider the main disadvantages of a traditional IRA. It’s paying ordinary income tax rates. So when you take distributions in retirement, you pay the regular income tax rate, which is higher than the long-term capital gains tax rate that you would pay.

If your investments were in, let’s say a taxable brokerage account. In other words, investment owned in a taxable brokerage account, get more favorable treatment than they do in a retirement account. Another disadvantage is paying RMDs. As I mentioned, once you reach age 72, you must begin taking withdrawals and paying taxes. Even if you don’t need the money in your traditional IRA and paying early withdrawal penalties, that’s always a disadvantage. If you take distributions before age 59 and a half, you must pay income tax plus that additional 10% penalty. However, there are some penalty exceptions, including using the funds up to a limit to pay for your first home to pay for higher education expenses, medical bills, or even a tax delinquency. All right, now let’s switch gears and talk about the main advantages of Roth IRA. For sure. The price Mary benefit is avoiding future tax.

Having tax-free income and retirement is something to look forward to, especially if the capital gains tax rate goes up or it exceeds the ordinary income tax rate, you end up paying lower taxes. If you believe that you’ll learn more in retirement than you do right now, you can pay less tax upfront on Roth, IRA contributions than you would on traditional IRA withdrawals in the future. For instance, if you’re young or you’re just starting your career, your income and your tax rate may be much lower now than it will be when you retire. So that’s always why experts will recommend that young people get a Roth IRA. It just makes more sense because it’s very likely that they’re earning less, they’re paying less tax right now than they will in the future. Another benefit is passing money to errors. Since you never have to spend Roth IRA funds, you can leave them in the account and pass them on to your errors and making penalty free withdrawals.

You can withdraw your original contributions from a Roth IRA at any time without having to pay taxes or a penalty. And once you’ve owned the account for five years and you’ve reached age 59 and a half, you can also withdraw your account earnings penalty free. Also avoiding conflicts with workplace retirement plans is a benefit. You can max out both a retirement plan at work and Roth IRA every year with no conflict. And as I mentioned, getting tax-free retirement income, that’s, that’s a major having less taxable income and retirement gives you more money to spend. Plus it may reduce the likelihood that you’ll be required to pay taxes on social security, retirement benefits. And the last benefit that I’ll mention is being able to invest on an after-tax basis. Theoretically, you should be able to invest more post-tax or after tax to a Roth IRA than you could with a traditional account.

For example, a $5,000 Roth IRA contribution would be equivalent to a traditional pretax contribution of $6,667. Assuming a 25% tax rate. All right, now let’s consider the main disadvantages of a Roth IRA. The main one is not getting an upfront tax break. Since you’ve got to pay tax upfront on those Roth, IRA contributions, you just don’t get a tax break or reduce your taxable income in the year. You make the contributions that could cause you to miss certain tax deductions and credits that have qualifying income thresholds. Another disadvantage is of course, paying early withdrawal penalty fees on your earnings taking distributions before age 59 and a half means you’ve got to pay income tax plus that additional 10% penalty on the earnings portion of your Roth IRA. As I previously mentioned, there are penalty exceptions, and they also apply to the Roth IRA, including spending funds on your first home, higher education, medical bills or a tax delinquency.

And I think for some people, a downside of the Roth IRA is simply having an unknown tax future. If the government changed the rules and tax-free withdrawals from a Roth, IRA were no longer allowed. That would mean that you end up paying taxes twice. As I mentioned, that’s very unlikely, but some people believe it’s a Roth IRA downside. As you can see a significant factor in whether you should choose a traditional or a Roth IRA depends on your future income and tax rate. And that’s impossible for any of us to know. So you really just have to make your best guesstimate to sum it all up. If you prefer a bird in the hand and you want to save money on taxes sooner, rather than later, a traditional IRA should appeal to you. But if you don’t mind paying taxes in the current year, then a Roth IRA has many advantages.

And if you’re still undecided, why not split your investments into both types of IRAs, you can contribute to a traditional and Roth IRA in the same year, as long as you don’t exceed the annual allowable limit. For instance, if you’re under age 50, you could put thousand dollars in a traditional IRA and 3000 in a Roth IRA or any proportion you like for 2021. And before we go, I’m going to leave you with one final tip, which is if you have a workplace retirement plan and you get matching funds from your employer, be sure to contribute enough to max out the match before you put any money in an IRA, because that free matching is free money. And if you don’t take it, it’s just like throwing money away. So you want to prioritize that retirement plan at work with the matching before you start contributing to a traditional or a Roth IRA.

All right, we covered a lot here and maybe you’ll go back and listen to the podcast again. If the traditional and Roth is kind of getting fuzzy in your mind, that’s the beauty of podcast, right? You can just play it again. I want you to stay in touch with me one way is to follow me on Instagram at Laura D. Adams, you might also join my private Facebook group called dominate your dollars. You can send me a quick text to get your invitation to the group. Just text the word dollars. D O L L a R S to the number 3, 3, 4, 4, 4. Also visit Laura D adams.com to sign up for my newsletter. Learn more about me, my work books and online courses. That’s all for now. I’ll talk to you next week. I’ve been getting a lot of questions lately about inflation. So that’s what we’re going to talk about next week. So I hope you’ll join me until then. Here’s to living a richer life. Money girl is produced by the audio wizard, Steve Ricky Berg with editorial support from Biana Centura.

If you’ve been enjoying the podcast, we would love for you to rate and review the show. And don’t forget the backlist episodes and show notes are always available for you@quickanddirtytips.com.

If you plan to have a financially comfortable retirement, there’s no getting around the fact that you should use one or more tax-advantaged retirement accounts. I’m a big fan of the Individual Retirement Account or IRA because it’s available to anyone with some amount of earned income, no matter if you’re a teen or a retiree.

Unfortunately, I’ve found that many people have questions about IRAs that keep them from opening one up. For instance, they’re unsure how IRAs work or whether they should have a traditional or Roth account.

This post will clear up any confusion you may have about IRAs. Keep reading to find out if a traditional or Roth is best for you, where to open your account, and how to invest IRA contributions wisely.

What is an Individual Retirement Account (IRA)?

An important concept to understand about an IRA (or any retirement account, for that matter) is that it’s not an investment. An IRA is an account where you put your investments. 

I think of a retirement account like your house or apartment. It shelters and protects you, but it isn’t you. Similarly, an IRA is just a shelter that protects your investments from taxation while you own them inside the account.

You can put just about any investment in an IRA, such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, index funds, certificates of deposit (CDs), and money market funds. If you open a self-directed IRA, you can even own less mainstream investments, such as real estate or businesses in your account. But we’re just going to focus on traditional and Roth IRAs here.

What is a Traditional IRA?

First, let’s cover a traditional IRA and its benefits. A traditional IRA is available to anyone with earned income, including wages, salaries, commissions, taxable alimony, and self-employment income. For the purposes of an IRA, some types of income are excluded, such as earnings and profits from real estate, interest income, and pension or annuity income. 

Note that before January 1, 2020, you had to be under age 70.5 to qualify to make contributions to a traditional IRA, but that’s no longer the rule. You can continue making contributions as long as you have the earned income that I just mentioned.

Another critical point is that if you don’t have earned income, but you’re married and your spouse does, you qualify for a spousal IRA. That means your spouse’s income can be contributed to your IRA.

For 2021, you can contribute an amount equal to your (or your spouse’s) earned income up to $6,000. However, if you’re over age 50, you can make an additional annual “catch up” contribution of $1,000, for a total of $7,000.

What are the Benefits of a Traditional IRA?

The primary benefit of owning investments in a traditional IRA is that you don’t pay tax on the money you put in the account. In other words, your contributions are tax-deductible. However, your future withdrawals of contributions and earnings are subject to your ordinary income tax rate at the time.  

Let’s say you’re 35 years old, earn $35,000, and file taxes as a single person. If you max out your traditional IRA by contributing $6,000 in 2021, you only pay tax on $29,000, not on $35,000. Your $6,000 IRA contribution gives you a tax savings of about $720! Every dollar that you contribute to a traditional IRA reduces your taxable income.

One rule to know is that if you (or a spouse) participate in a retirement plan at work, you can still max out a traditional IRA; however, some or all of your contributions may not be tax-deductible, depending on your income.

As your IRA investments grow in value, you’re never taxed on those earnings until you take them out of the accounts. If you owned those investments in a regular, taxable brokerage account, you’d have to pay tax on your investment gains every year.

So, a traditional IRA allows you to defer paying taxes on both your contributions and earnings until you withdraw money in the future. You can begin making distributions penalty-free once you reach the official retirement age of 59½. And you must start taking required minimum distributions (RMDs) after age 72. 

If you tap a traditional IRA before 59½, in most cases, you must pay income taxes on the withdrawal, plus an additional 10% early withdrawal penalty. That’s why I never recommend breaking open your retirement piggy bank–it’s just too expensive!

What is a Roth IRA? 

Now, we’ll switch gears and cover the Roth IRA. Unlike the traditional, a Roth is only available when you earn less than an annual threshold. I’ll give you the details on that limit in a moment. 

For 2021, the amount you can contribute to a Roth IRA is the same as for a traditional IRA. You can put in an amount equal to your earned income up to $6,000 or $7,000 if you’re over age 50. Like with a traditional IRA, you can make Roth IRA contributions no matter your age if you have qualifying earned income.  

What are the benefits of a Roth IRA?

A Roth IRA is similar to a traditional in many ways, except that it comes with different tax benefits. While the money you put in is not tax-deductible, your withdrawals are entirely tax-free! 

Using my previous example, let’s say you’re 35 years old, earn $35,000 and contribute $6,000 to a Roth IRA. You’d have to pay tax on your total earnings of $35,000. 

But the fantastic feature of a Roth IRA is that you’ll never owe another penny in taxes, not even on the potentially massive amount of account growth that accumulated over decades! Having tax-free investment growth and retirement income is a huge deal.

Additionally, there’s no rule that you must take RMDs starting at age 72, as there is with a traditional IRA. Your Roth IRA money can sit in your account forever if you wish. And you can easily pass it to your heirs. 

The last significant benefit of having a Roth IRA is that it’s the most flexible type of retirement account for taking money out. Since you must pay tax upfront on your contributions, you can take them as distributions at any time. Even if you’re younger than 59.5, you can tap your original contributions and spend them any way you like, penalty-free.

However, there are different rules for the earnings portion of a Roth IRA because you haven’t paid tax on them yet. Once you’ve owned the account for five years and reach age 59.5, you also qualify to withdraw earnings penalty-free. But if you’re younger than 59.5, investment earnings you take out will be subject to income tax plus an additional 10% penalty.

Be aware that the Roth IRA five-year rule supersedes reaching the retirement age. In other words, even if you’re over age 59.5, if you haven’t owned the account for at least five years, the earnings portion of your distribution is taxable. However, once the five-year waiting period is up, you’re in the clear and can make entirely tax-free Roth IRA distributions. 

To avoid violating the Roth IRA five-year rule, it’s smart to open one sooner rather than later. That ensures you’ll never be in a situation where you must pay tax on some of your Roth distribution.

What are the Roth IRA Income Limits?

I mentioned that you can’t have a Roth IRA when you’re a high earner. The upper income limit depends on your tax-filing status and modified adjusted gross income. Here are the top income thresholds to qualify for Roth IRA contributions for 2021:

  • Single taxpayers must earn less than $140,000. 
  • Married taxpayers who file jointly must earn less than $208,000.

If you qualify to contribute to a Roth IRA but have income that’s too high later on, pat yourself on the back! It’s no problem because you can keep your Roth IRA open indefinitely and enjoy its tax-free growth. However, you won’t be allowed to make any new contributions unless your income dips below the annual limit in any given year.

What are the pros and cons of Traditional and Roth IRAs?

If you’re eligible to contribute to either a traditional or a Roth IRA, which one should you choose? I’ll summarize the advantages and disadvantages of each, so you know what’s best for your situation. 

Here are the main advantages of a traditional IRA: 

  • Paying less tax. Contributions reduce your taxable income for the year–unless you or a spouse have a retirement plan at work and earn over an annual income limit.
  • Deferring tax. If you believe your income or tax rate in retirement will be lower than it is now, deferring tax until you make withdrawals may be a wise move. For instance, if you’re middle-aged or know that your career earnings have peaked, a traditional IRA may save you money on taxes. 
  • Timing your future tax. You can begin taking penalty-free withdrawals and, of course, pay tax on them starting at age 59½.
  • Avoiding potential additional taxation. Since you only pay tax on traditional IRA withdrawals, that may give you peace of mind that your retirement funds could never be taxed twice, upfront and later on in retirement. It’s not likely that double taxation on retirement accounts could pass legislation, but some worry about it. 

Now consider the main disadvantages of a traditional IRA:

  • Paying ordinary income tax rates. When you take distributions in retirement, you pay the regular income tax rate, which is higher than the long-term capital gains tax rate. In other words, investments owned in a taxable brokerage account get more favorable tax treatment than a retirement account. 
  • Paying RMDs. Once you reach age 72, you must begin taking withdrawals and paying taxes, even if you don’t need the money in your traditional IRA. 
  • Paying early withdrawal penalties. If you take distributions before age 59.5, you must pay income tax plus an additional 10% penalty. However, there are some penalty exceptions, including using the funds (up to a limit) to pay for your first home, higher education expenses, medical bills, or tax delinquency.

Here are the main advantages of a Roth IRA: 

  • Avoiding future tax. Having tax-free income in retirement is something to look forward to, especially if the capital gains tax rate goes up or exceeds the ordinary income tax rate.
  • Paying lower taxes. If you believe you’ll earn more in retirement than you do now, you can pay less tax upfront on Roth IRA contributions than traditional IRA withdrawals in the future. For instance, if you’re young or just starting your career, your income and tax rate may be much lower now than when you retire.
  • Passing money to heirs. Since you never have to spend Roth IRA funds, you can leave them in the account for heirs.  
  • Making penalty-free withdrawals. You can withdraw your original contributions at any time without having to pay taxes or a penalty. And once you’ve owned the account for five years and reach age 59.5, you can also withdraw your account earnings penalty-free.
  • Avoiding conflicts with workplace retirement plans. You can max out both a retirement plan at work and a Roth IRA every year. 
  • Getting tax-free retirement income. Having less taxable income gives you more money to spend in retirement. Plus, it may reduce the likelihood that you’ll be required to
    pay taxes on Social Security retirement benefits.
  • Investing on an after-tax basis. Theoretically, you should be able to invest more post-tax to a Roth IRA than a traditional account. For example, a $5,000 Roth IRA contribution would be equivalent to a traditional pre-tax contribution of $6,667, assuming a 25% tax rate. 

Now consider the main disadvantages of a Roth IRA:

  • Not getting a tax break. Since you must pay tax upfront on Roth IRA contributions, you don’t get a tax break or reduce your taxable income in the year you make them. That could cause you to miss certain tax deductions and credits with qualifying income thresholds.
  • Paying early withdrawal penalties on earnings. Taking distributions before age 59.5 means you must pay income tax plus an additional 10% penalty on the earnings portion of your Roth IRA. As previously mentioned, there are penalty exceptions, including spending funds (up to a limit) on your first home, higher education, medical bills, or tax delinquency.
  • Having an unknown tax future. If the government changed the rules and tax-free withdrawals from a Roth IRA were no longer allowed, that would mean paying taxes twice. As I mentioned, that’s highly unlikely, but some people believe its a Roth IRA downside.  

Should you choose a Traditional or a Roth IRA?

As you can see, a significant factor in whether you should choose a traditional or a Roth IRA depends on your future income and tax rate. Since they’re impossible to know, you must make your best guestimate.

If you prefer a “bird in the hand” and want to save money on taxes sooner rather than later, a traditional IRA should appeal to you. But if you don’t mind paying taxes in the current year, then a Roth IRA has many advantages. 

And if you’re still undecided, why not split your investments into both types of IRAs? You can contribute to a traditional and a Roth IRA in the same year as long as you don’t exceed the annual limit. For instance, if you’re under age 50, you could put $3,000 in a traditional IRA and $3,000 in a Roth IRA, or in any proportion you like, for 2021.

And a final quick and dirty tip is that if you have a workplace retirement plan and get matching funds from your employer, be sure to contribute enough to max out the match before you put any money in an IRA.

This article originally appeared on Quick and Dirty Tips

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About the Author

Laura Adams, Quick and Dirty Tips

Laura Adams, Quick and Dirty Tips

Laura Adams is an award-winning author of multiple books, including Money Girl’s Smart Moves to Grow Rich. Her newest title, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, is an Amazon No. 1 New Release. Laura’s been the writer and host of the popular Money Girl Podcast, a top weekly audio show in Apple Podcasts, since 2008. She’s a frequent source for the national media and has been featured on most major news outlets including NBC, CBS, ABC FOX, Bloomberg, NPR, The New York Times, The Wall Street Journal, The Washington Post, Money, Time, Kiplinger’s, USA Today, U.S News, Huffington Post, Marketplace, Forbes, Fortune, Consumer Reports, MSN, and many other radio, print, and online publications. Millions of readers and listeners benefit from her practical financial advice. Her mission is to empower consumers to live richer lives through her podcasting, speaking, spokesperson, teaching, and advocacy work. Laura received an MBA from the University of Florida. Visit LauraDAdams.com to learn more and connect with her.

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