When you’re working on your retirement strategy, it’s to your advantage to explore every savings option possible. Funneling money into your 401(k) retirement plan or a similar workplace plan is a good first step but contributing to an individual retirement account — a Roth IRA or a traditional IRA — can help you fatten up your nest egg even faster.
Opening an IRA is also a smart move if you’re not eligible to participate in an employer’s plan.
Savers can choose between a traditional or Roth IRA account, depending on their situation. There are certain benefits that go along with each type of IRA but there are some key differences that you need to be aware of.
If you’re not sure which type of account is the best fit for you, here’s a look at how they compare.
Who can contribute?
The IRS has some guidelines in place that determine who can save money in a traditional or Roth IRA. For starters, you have to have some kind of taxable compensation during the year. That can be wages or tips earned at a job, commissions, alimony or self-employment income.
If you’re going the traditional route, there are no restrictions on how much money you can earn but your ability to contribute is limited by age. If you’re over age 70 1/2, you’re not eligible.
With a Roth IRA, there are no age limits but the amount you can put in each year is determined by your modified adjusted gross income.
For 2014, you can only chip in the full amount if your income is less than $114,000 and you file single, or less than $181,000 if you’re married and file jointly. Reduced contributions are allowed if you’re over those limits but they’re phased out completely once you hit $129,000 or $191,000 respectively.
How much can you save?
The amount of money you can save in either type of IRA is the same. For 2014, the maximum contribution limit was $5,500 or $6,500 if you’re over age 50. That doesn’t mean, however, that you can contribute to the full amount to both a traditional and Roth IRA account in the same year.
Even if you have several IRAs, the IRS considers them all to be the same for contribution purposes so you can only fund them up to the limit collectively, not individually.
Are contributions tax deductible?
Roth IRA contributions are not tax-deductible but the money you put into a traditional IRA is a different story.
Whether you can claim a deduction is ultimately determined by your filing status, income and participation in an employer’s retirement plan. For example, single filers who are covered by an employer’s plan can claim the full deduction for 2014 if their modified adjusted gross income is $60,000 or less.
If you’re not covered by an employer’s plan then your deduction is only affected by income if you’re married and your spouse is saving for retirement through their employer.
For 2014, joint filers in this scenario would only be eligible for the full deduction if their combined income was $181,000 or less. Single filers can deduct their total contribution, regardless of how much they earn, as long as they’re not covered by a company plan.
Are distributions taxed?
Contributions to a traditional IRA are made with pre-tax dollars, so while you get the deduction up front you still have to pay taxes on the money at some point. Once you start taking qualified distributions of contributions or earnings, you’ll have to count them as income, which means they’ll be taxed at your regular rate.
If you take money out of a traditional IRA before you turn 59 1/2, you’ll also get hit with an additional 10% early withdrawal penalty. You also have to start taking required minimum distributions once you reach age 70 1/2 in order to avoid a tax penalty.
The rules for withdrawing from a Roth IRA are a little different. Generally, you can withdraw your original contributions at any time, tax and penalty-free.
If you’re taking out earnings, you won’t pay any taxes on those either as long as your account has been open for at least five years and you’re over age 59 1/2. There are some exceptions to this rule if you’re using the money to buy a first home or you’ve become permanently disabled. Unlike a traditional IRA, you’re not required to start taking distributions once you reach a certain age.
Making a final decision on traditional vs Roth IRA
If you’re on the fence about whether to open a traditional or Roth IRA, weighing the tax benefits can help you make a final decision.
Opting for a traditional IRA, for instance, makes sense if you want to reduce your taxable income now, which may allow you to qualify for additional tax credits or deductions.
On the other hand, if you expect your income to be higher once you retire, you may be better off going with a Roth IRA since you’d be paying the tax on contributions at your current rate.
You should also look at how long you plan to save. With a traditional IRA, there’s a definite cut-off on how long you have to make contributions.
A Roth IRA offers more flexibility, especially if you plan to continue working past traditional retirement age or you want to accumulate more assets for your spouse or other heirs. Just keep in mind that while beneficiaries wouldn’t have to pay income tax on withdrawals, they may still be subject to estate tax.