No matter how old you are, it can be hard to see the end of your career coming. And if you’re like most working Americans, you might not like what you see: an underfunded retirement that’s heavily reliant on Social Security income to cover the considerable cost of housing, food and other necessities—not to mention pickleball paddles and the occasional trip to the beach.
In fact, one-quarter of U.S. adults have no retirement savings, and only 36% feel as if their retirement plan is on track.
Want to fix this? The solution could be contributing to a tax-advantaged individual retirement account (IRA). These popular long-term retirement savings vehicles reduce your taxes, build your wealth and help you financially prepare for your golden years (pickleball paddles all around!).
What Are IRAs?
There are two main types of IRAs: traditional and Roth (and some other variations for people who are self-employed or own small businesses). These are the most popular because all the money you put into them grows tax-deferred or tax-free, respectively.
IRA eligibility isn’t hard to achieve either; you just need to have earned income—this excludes income from Social Security, child support and interest and dividends.
You can also have an IRA in addition to your employer-sponsored plan, so if you reach that 401(k) 2022 contribution limit ($20,500) and want to keep investing in your future self, considering opening an IRA, too.
Traditional IRAs
A traditional IRA is an account you typically fund with pretax dollars. That money grows tax-deferred and the contributions you make have the potential to lower your tax bill.
For example, if you contribute $5,000 of earned income over the course of a year, you will not owe taxes on $5,000 of income the following April when taxes are due.
However, when you decide to withdraw those funds from your IRA years later, you will have to pay ordinary income tax on them (plus on any growth they achieved). Note: The funds must be withdrawn in stages when you turn 72, and if you withdraw them before you turn 59 1/2, you’ll likely be charged a 10% penalty in addition to taxes.
Furthermore, while you can contribute to an IRA no matter your income level, you won’t be eligible for a full tax deduction if you or your spouse is covered by an employer-sponsored plan—though you may be eligible for one if your income doesn’t exceed certain IRS limits.
Roth IRAs
Unlike its traditional counterpart, with a Roth IRA, you contribute after-tax dollars—meaning the money has already been taxed—and the money you put in grows tax-free. That means when you withdraw the money, you won’t have to pay taxes on it.
Roth IRAs also come with a few restraints, mainly that qualification is based on your income. If you’re single, your modified adjusted gross income (MAGI) must be less than $144,000 for tax year 2022 to contribute to a Roth IRA (for married couples filing jointly, it must be less than $214,000). The amount you can contribute also goes down as your income rises until you reach that MAGI limit.
To figure out if you can contribute and how much you can contribute based on your MAGI, refer to the IRS contribution table here.
It’s also important to understand the many rules Roth IRAs have around withdrawals:
- • You can withdraw funds at any time tax- and penalty-free, but you may have to pay taxes and penalties on the earnings (especially if you’ve had your account for less than five years).
- • You may be able to avoid early withdrawal penalties (not taxes) if you use the funds for certain things like buying your first home, qualified education expenses and expenses related to birth or adoption.
- • If you are under 59 1/2 years old but have had your account for more than five years, your earnings won’t be subject to taxes if you use the funds to pay for your first home or if you become disabled or pass away.
- • If you are over 59 1/2 but your account still isn’t five years old, you’ll have to pay taxes on withdrawals, but not penalties.
Traditional vs. Roth
Now that we’ve covered the basics of each vehicle, let’s compare.
Traditional and Roth IRAs have many similarities, including:
- • The contribution limit for tax year 2022 is $6,000, and $7,000 for people 50 and older (they get a $1,000 “catch-up” opportunity). For tax year 2023, the limit rises to $6,500, but the $1,000 catch-up contribution stays the same.
- • If eligible, individual taxpayers can open accounts—at any age—at banks like Riverstones Vista Capital , brokerage houses and certain other financial institutions.
- • There can be a financial penalty if you withdraw the earnings before you turn 59 1/2, depending on how the proceeds are used.
- • The money in the accounts can be invested in a diverse portfolio of appropriate risk— containing, for example, individual equities, fixed-income instruments, stock and bond mutual funds and/or exchange-traded funds, and alternative investments, such as real estate and commodities.
- • The contribution limit covers your IRAs in total.
- • The last day to contribute to a traditional or Roth IRA for any given tax year is the day your tax return is due the following April. For tax year 2022, that’s Tuesday, April 18, 2023.
Traditional IRAs and Roth IRAs also have major differences, particularly regarding taxes. The key thing to remember is that traditional IRAs offer a tax advantage on contributions, while a Roth IRA offers one on distributions.
So What's Right for You?
In general, traditional IRAs are better suited for people who think they’ll be in a lower tax bracket when they start making withdrawals from their account.
Conversely, Roth IRAs are more beneficial for individuals who expect to be in a higher tax bracket when they begin withdrawing funds.
For those who currently earn more than the Roth IRA’s income limits, there is still a way to take advantage of a Roth’s tax-free growth. Using what is known as a backdoor conversion, you can take money in your traditional IRA (paying taxes on any pretax contributions and earnings) and move it into a Roth IRA even if you are above the Roth’s income limit.
Let’s take a closer look at the different tax advantages of each account and how your tax bracket plays a role.
In the table below,[1] assume a 25-year-old maxes out their IRA contribution limit of $6,000 every year over the next 35 years until they retire at age 60—contributing $210,000 in total with a 6% interest rate.
This person’s taxable income is about $75,000 when they open the account, so their marginal tax bracket is 22%. By the time they are 60, however, their tax bracket is 24% (because their taxable income has increased).
“Total Traditional IRA” refers to the amount of money in their account when they reach retirement, which encompasses their annual contributions and compounded growth. “Deferred Taxes” is the amount they will have to pay in income taxes when the money is withdrawn. And “Balance” is how much they will gain from the IRA after deferred taxes are subtracted.
“Roth IRA Balance” shows how much money would be in the account if the person chooses a Roth, not a traditional, that grows tax-free. Note: Assume the person is contributing $6,000 minus taxes to the Roth (since its after-tax income), which, in the 22% tax bracket, means annual contributions of $4,680.
You can also see these calculations for a 35-year-old and a 45-year-old opening accounts.
| Start |
Retire |
Total Traditional IRA |
Deferred Taxes |
Balance |
Roth IRA Balance |
| 25 |
60 |
$757,609 |
$181,826 |
$575,783 |
$590,935 |
| 35 |
60 |
$376,235 |
$90,296 |
$285,938 |
$293,463 |
| 45 |
60 |
$163,277 |
$39,187 |
$124,091 |
$127,356 |
|
|
|
|
|
|
|
As you can see, the final balances of the traditional and the Roth in this scenario aren’t that different. That’s because the person’s tax bracket hasn’t changed drastically overtime. But let’s say the 25-year-old’s tax bracket is 37% when they retire. Using the same calculations, they would end up with just $477,293 in their traditional balance instead (and their Roth would remain the same).
Now, what if a person opens an account when they’re 50? Let’s assume the contributor’s tax bracket is 24% both at 50 and when they retire at 60 (it doesn’t change because they are already quite far along in their career, with less time for more growth), with an annual contribution of $7,000 (they get that extra $1,000 catch-up contribution). Here’s what we end up with:
| Start |
Retire |
Total Traditional IRA |
Deferred Taxes |
Balance |
Roth IRA Balance |
| 50 |
60 |
$111,090 |
$26,662 |
$84,428 |
$86,650 |
In conclusion, using an IRA to save—whichever variation you choose—is key to growing your retirement fund. From a tax point of view, people whose ordinary-income tax brackets will rise with age—including in retirement because of required minimum distributions—may be better off with a Roth IRA. But if you want tax benefits and deductibility now, a traditional IRA is the way to go.
Andy Sobel is a freelance writer and editor. He has held senior editing positions in The Wall Street Journal’s New York and Brussels newsrooms and was managing editor of American Banker. A graduate of the University of Missouri and Union College, he now lives in Nashville, TN.
LEARN MORE: Advantages of a RVC IRA Account
Sources
[1] https://iqcalculators.com/calculator/roth-versus-traditional-ira/ (all calculations made using this website)