As of 2019, research from the Congressional Research Service, CRS, estimated that only 25.3% of U.S. households owned either a Traditional IRA or Roth IRA.[1] Also, only 66% of American workers have access to employer-sponsored defined contribution plans based on a study from the U.S. Bureau of Labor Statistics in 2017.[2] Social Security Benefits alone will not cover your expenses in retirement and maximizing contributions to your retirement plan at work as well as an Individual Retirement Account are essential to meet your retirement income goals.
What’s an IRA and the difference between a Traditional and Roth?
Traditional IRA and Roth IRA’s are both retirement vehicles that allow individuals to save for retirement with different tax advantages. For 2021, the maximum you can contribute combined is $6,000 if you are under 50 and up to $7,000 if 50 or older. You must have earned income in order to contribute to either plan. If one spouse does not work, a spousal IRA can be set-up in their name as long as the amount contributed is within the earned income threshold and contribution limits of $6,000 per a spouse.
The Traditional IRA
A Traditional IRA provides taxpayers with a current tax break based on your marginal tax rate for the year and defers the income in the account until withdrawals are made in retirement. Most 401(K) plans are similarly set-up the way that Traditional IRA’s are in that money contributed to the plan is before-tax dollars. There are no taxes paid on the contributions and the growth of the Traditional IRA until withdrawals are made. One of the benefits that a Traditional IRA may offer over your retirement plan at work is that you can open the account at any brokerage firm you like- Schwab, Fidelity, Vanguard, etc. With that comes the flexibility to invest in hundreds of commission-free individual stocks, Exchange Traded Funds (ETF’s), and mutual funds at very low expense ratios while most likely limited to more expensive mutual funds in your 401(K) or employer plan. This is generally one of the main reasons to invest in an IRA over your retirement at plan at work after contributing the maximum amount to receive the employer match if offered by your plan. One of the biggest advantages a retirement plan or 401(K) has over an IRA is that you can contribute much more to the account - $19,500 vs $6,000 for IRA’s.
There are income limitations on deductibility of contributions if you have a retirement plan at work for a Traditional IRA so consult your tax advisor or CPA to find out what your Modified Adjusted Gross Income (MAGI) will be for the year. If your spouse has a retirement plan but you don’t, you can have a MAGI of $198,000 and still receive the full deductibility and a reduced deductibility up to $208,000. Please refer to the chart below for more details.
IRS Traditional IRA Deductibility Chart
One of the major disadvantages of the Traditional IRA vs the Roth IRA is the IRS requires those that reach age 72 to take Required Minimum Distributions (RMD’s) based on a table that you divide the balance of all your IRA’s on December 31st of the previous year from a set distribution number based on your age. This number increases the percentage you have to withdraw each year you get older from the IRA to pay income taxes on. Every dollar taken out of your IRA is taxable income as the taxes were deferred to allow the portfolio to grow until making withdrawals in retirement.
The Roth IRA
Just like the Traditional IRA, the Roth IRA has a contribution limit of earned income of $6,000 for 2021 or $7,000 if you are age 50 or older for catch-up contributions. You are also able to invest in a wide variety of index funds, Exchange Traded Funds, mutual funds, and individual stocks that are not widely available in an employer retirement plan. The difference is how the tax treatment works for Roth IRA vs a Traditional IRA. There are no Required Minimum Distributions on Roth IRA’s as there is for Traditional IRA’s at age 72. As discussed earlier, contributions to a Traditional IRA are tax-deferred and no income taxes are paid until distributions are made (preferably in retirement or after 59 ½ to avoid penalty). Roth IRA contributions are made with after-tax dollars. The growth and income of the Roth IRA are tax-deferred and any withdrawals are tax-free as long as you are over the age 59 ½ and owned the account for at least 5 years. There are income limitations to be eligible to contribute to a Roth IRA – A modified Adjusted Gross Income of $198,000 for married filing jointly (reduced contribution amount up to $208,000), or $125,000 filing single, head of household or married filing separately. Thankfully, there is a workaround with a strategy often referred to as the backdoor Roth strategy. Without going into too much detail, if you earn too much income to contribute to a Roth, you may contribute to a nondeductible IRA and convert it a Roth IRA. There is a pro-rata rule in that if you have any existing Traditional IRA’s with a balance besides the current year contribution/basis, then you will owe taxes on a percentage of the total balance that was converted.
Conclusion
Whether you contribute to a Traditional IRA or Roth IRA generally depends on your current tax situation and what you think future tax rates will be. If you are eligible to contribute to one of the Individual Retirement Accounts in addition to your retirement plan at work and have additional savings to invest, it is highly recommended due to the tax favorable treatment they both receive of either deferred taxes or tax-free growth that a non-qualified brokerage account cannot provide. There are many nuances to retirement and investment planning and you can always reach out to our office at Mason Wealth Strategies by calling 678-439-8866 or our website at www.masonws.com and click “Start Here” to schedule a call or message us on Facebook at Mason Wealth Strategies, LLC | Facebook.
[1] Individual Retirement Account (IRA) Ownership: Data and Policy Issues (fas.org)
[2] Employee Benefits in the United States - March 2017 (bls.gov)
[3] IRS 2021 IRA Deduction Limits for Retirement Plan at work
Image courtesy of Earnest.com