When you sit down to plan out your financial life, one of the most important things to consider is retirement savings.
We know it can be hard to think about putting money away for the time when you’ll stop working 20, 30, even 40 years from now. But it’s critical to consider your future self, because the sooner you start building a nest egg, the more time can work with you to increase your savings.
Even if you don’t work for a company that offers you a retirement plan, you can set one up for yourself. Read on, and we’ll explain how!
Traditional IRA vs. Roth IRA
Individual retirement accounts, or IRAs, play a key role in helping people save for retirement. More than one-third of private-sector workers in the U.S. don’t have access to an employer-sponsored retirement plan such as a 401(k). The U.S. government helps to fill that gap through a part of the federal tax code that allows for IRAs, which are often offered through brokerage firms and other financial services companies, and which give individuals tax advantages to save for retirement.
There are two kinds of IRAs: Traditional and Roth. There are important differences between these account types, including how they’re taxed and who can contribute. Knowing the basics can help you choose the right IRA for you.
What’s the difference between Roth and Traditional IRAs?
The biggest difference between traditional and Roth IRAs is the timing of taxes.
With a traditional IRA, you’re taxed on money you withdraw from the account. However, you may not have to pay income tax on the money you contribute to a Traditional IRA and any earnings your investments generate aren’t taxed until you withdraw the money. That’s why Traditional IRAs are called tax-deferred.
Some other important facts to know about traditional IRAs: You’ll pay an early withdrawal penalty if you take money from the account before you reach age 59 ½, and every year after age 70 ½ you’ll be required to withdraw a minimum amount of money, called a required minimum distribution (RMD).
With a Roth IRA, taxes work the other way around. You pay tax on any income you contribute to the account. After that point you don’t have to pay any tax on that money or on any of its investment gains—you can withdraw any funds in the account tax-free, as long as you stick to some basic rules. In basic terms, the main difference between the two, with a Roth IRA you pay taxes now, and with a Traditional IRA you pay taxes later.
Individuals can withdraw Roth IRA contributions tax and penalty-free anytime, even before retirement. Not so for investment earnings: Withdraw them before age 59 ½ and you’ll pay taxes and penalties. Unlike traditional IRAs, Roth IRAs do not require minimum distributions.
Whether you choose a traditional or Roth IRA (or a combination—more on this below), your total contributions are limited to $6,000 in 2019, or $7,000 if you’re 50 or older.
Benefits of a Traditional IRA
Anyone who earns money from work can contribute to a traditional IRA. The accounts offer two main benefits: tax-deferred growth and the potential to lower your taxable income.
In an ordinary investment account, you generally pay taxes on some of your investment gains each year. With a traditional IRA, your money isn’t taxed until you withdraw it. The tax deferral can leave more gains for you to reinvest, and that’s a big deal: Continually reinvesting gains that otherwise would have been lost to taxes is called tax-deferred compounding, and it can help your retirement savings grow exponentially.
Your traditional IRA contributions may lower your taxable gross income by an amount equivalent to your contribution, and in turn how much income tax you pay on your adjusted gross income, or AGI.
If you are covered by a workplace plan, you may also contribute to a traditional IRA. However, whether and how much your contributions will reduce your taxable income depends on your AGI. In 2019, people who file taxes singly and have AGI of $64,000 or less can deduct the full amount they contribute. The deductible amount phases out at higher income levels, reaching zero for single filers with an AGI of $74,000. Couples who are married and filing jointly can take a full deduction if they have AGI of $103,000 or less, and the deduction phases out until it disappears at $123,000.
Benefits of a Roth IRA
Roth IRAs have two big benefits: tax-free growth on your investments and tax-free income in retirement.
Like a traditional IRA, a Roth IRA allows investment gains to grow without taxes. That advantage leaves more money for you to reinvest. Repeated over time, this tax-advantaged compounding can supercharge your ability to build retirement savings.
What’s more, you don’t have to pay any tax on withdrawals of earnings from a Roth IRA after age 59 ½. You may withdraw contributions tax-free at any time. Not having to pay taxes on that income may be extremely helpful for your retirement budget. And Roths aren’t subject to RMDs, so you can leave the money in the account as long as you like.
How much can I contribute to a Roth IRA?
Income limitations affect how much you can contribute to a Roth IRA, or whether you can contribute at all. In 2019, contributions phase out for single filers making between $122,000 and $137,000. In other words, if your income is within this range, the contributions you can make gradually get smaller as your income gets larger. You can no longer contribute when your earnings reach $137,000. Contributions for couples who are married and filing jointly phase out with annual earnings between $193,000 and $203,000.
Traditional IRA vs. Roth IRA Comparison
|Traditional IRA||Roth IRA|
|Contribution limits||$6,000, or $7,000 for ages 50 and older in 2019.||$6,000, or $7,000 for ages 50 and older in 2019.|
|Tax benefits||Tax-deductible contributions and tax-deferred growth.||Tax-free growth and tax-free withdrawals.|
|Withdrawals||Withdrawals made before age 59 ½ are generally subject to income tax and a 10% penalty, with some exceptions. After age 59 ½ you are no longer subject to the penalty.||Withdrawals of contributions are penalty and tax free. Before age 59 ½, withdrawals of earnings are subject to income tax and a 10% penalty, with some exceptions.|
|Required Minimum Distributions (RMDs)||RMDs must be taken starting in the year you turn 70 ½.||RMDs do not apply.|
|Income requirements||Your income does not limit how much you can contribute, but can limit how much of your contribution you can deduct, if you’re covered by a workplace plan.||Your income may limit the amount you contribute.|
|Age requirements||You can contribute up to age 70 ½.||There are no age limits on Roth contributions as long as you have earned income.|
Can you have both a traditional IRA and a Roth IRA?
You can have both a traditional and a Roth IRA at the same time. But your total contribution to both can’t exceed the contribution limits: $6,000 in 2019, or $7,000 for people who are 50 or older.
For example, say you are younger than 50 in 2019 and you make a $2,500 contribution to your Roth IRA. In that case, you can also contribute up to $3,500 to your Traditional IRA.
Making the right decision for you
Which IRA is better? It depends on your personal financial situation. If you earn a high salary, a traditional IRA may be your best bet, because income limits probably prevent you from contributing to a Roth. Traditional IRAs also may be useful for reducing your taxes in a given year—especially if your contribution bumps you down into a lower tax bracket.
You might want to consider your current and potential future tax brackets, too. Contributing to a traditional IRA could lower your taxes in the present, deferring them until you withdraw the money in retirement. These accounts may be the better choice if you think your tax bracket may be lower when you’re retired as you may pay less in taxes in the present and in the future.
Conversely, a Roth may be the better choice if you think you’ll be in a higher tax bracket when you retire, since you won’t have to pay taxes on your withdrawals. Similarly, you might consider funding a Roth if you’re just starting your career and have a relatively low salary. You’ll pay taxes at a low rate now, and not have to pay taxes on distributions, when you withdraw the money later.
Many people use both traditional and Roth IRAs. The flexibility that comes with having both can help manage taxes in retirement.
Which IRA should I choose for the long term?
The potential tax benefits offered by each type of account can help you grow your savings faster than you could in a regular investment account. Traditional accounts may be best for high earners, people looking to lower their taxes now, and those who believe they may be in a lower tax bracket when they retire. Roth IRAs may be good for lower earners and people who think they may be in a higher tax bracket when they retire since withdrawals of contributions from Roths are tax-free.
Here’s the good news: Whether you contribute to a traditional IRA or a Roth IRA, or a combination of the two, both types of IRA can help you build financial freedom.
Stash can make it easy to get started. In fact, people who join Stash tend to increase their savings and investments by about $40 per month1. To learn more about opening an IRA and start saving today, visit Stash Retire.