You're ready to save for retirement in an IRA. But wait, there are 2 types of IRAs—a traditional IRA and a Roth IRA. Which one should you choose? You may be able to contribute to both types. Here are some things to keep in mind as you decide which is the appropriate choice for you now.
First, the basics. Traditional and Roth IRAs are both types of tax-advantaged accounts designed to help people save for retirement. For 2018, eligible taxpayers can contribute up to $5,500 (or up to the level of earned income, if lower) to a traditional IRA, or $6,500 if they have reached age 50. The limit for 2019 contributions is $6,000—or $7,000 for people over age 50.
The same amounts can be contributed to a Roth IRA, as long as your income (as defined by modified adjusted gross income, or MAGI) is not above the limits: The ability to contribute to a Roth IRA starts to phase out at $189,000 in 2018 and $193,000 in 2019, if you are married and file a joint return. If you are a single filer, the phase-out begins at $120,000 in 2018 and $122,000 in 2019).
There is an earned income requirement to contribute to an IRA. You, or your spouse, must have taxable earned income of at least your contribution amount.
Which kind of IRA?
With a traditional IRA, your contribution may reduce your taxable income and, in turn, your federal income taxes if you are eligible for the tax deduction.1 Earnings can grow tax-deferred until withdrawn, although if you make withdrawals before age 59½, you may incur both ordinary income taxes and a 10% penalty. (There are a handful of situations that may qualify for waiving the early withdrawal penalty.) After age 59½, you may make withdrawals of any amount without penalty, but federal and state taxes, if applicable, will apply. Starting in the year you reach age 70½, you will need to begin taking at least the required minimum distributions (RMDs) and paying ordinary income taxes on the distribution amount.
To estimate your tax savings on a traditional IRA contribution, you'll need your marginal tax rate. Then multiply it by the amount of money you contributed to your traditional IRA. That's generally how much a traditional IRA may reduce your federal income tax. (Keep in mind that it's an estimate. In some cases your contribution can reduce your marginal tax rate, so your federal tax savings might be smaller. On the other hand, you might also save on state income taxes.) For instance, a person with a 25% marginal federal income tax rate would save $1,375 in taxes on a contribution of $5,500.
While everyone with earned income can contribute to a traditional IRA, if you and/or your spouse also have access to a workplace plan like a 401(k), your ability to deduct your traditional IRA contribution may be limited so you may want to prioritize the workplace plan. The most common types of workplace plans, 401(k)s, 403(b)s, and 457s allow participants to save more than 3 times the annual IRA contribution limit. Money saved in the traditional types of these accounts reduces your taxable income for the year. Saving first in the account that offers the biggest tax benefit could help you make the most of your savings.
With a Roth IRA, your contribution isn't tax-deductible the year you make it, but your money can grow tax-free and your withdrawals are tax-free in retirement, provided that certain conditions are met.2 Eligibility to contribute to a Roth depends only on MAGI—a retirement plan at work for you or your spouse is not a factor. As long as your MAGI is beneath the annual limit, you can contribute to a Roth IRA.3
Earnings on those contributions (although not the contributions themselves) may be subject to both tax and early withdrawal penalties if withdrawn before the qualifying criteria are met.2 As with the traditional IRA, there are some circumstances that qualify for an exception to the 10% penalty—like buying a first home or paying qualified educational expenses. Because Roth contributions are made after taxes have been paid, you can withdraw your contributions anytime, with no taxes or penalties due.
Unlike traditional IRAs, Roth IRAs do not have RMDs (during the original owner's life).
If your spouse doesn't work, they can have a spousal IRA. This allows non-wage-earning spouses to contribute to their own traditional or Roth IRA, provided the other spouse is working and the couple files a joint federal income tax return. If the working spouse is covered by a retirement plan at work, deductibility of contributions to a spousal traditional IRA would be phased out at higher incomes.1 This means eligible married spouses can each contribute up to the contribution limit each year to their respective IRAs.4 Spousal IRAs are also eligible for a $1,000 catch-up contribution for those 50 and older.
Making a decision
But tax rates don't tell the whole story. "How disciplined you are at saving can also play a role in which type of account may better help you prepare for retirement," explains Matthew Kenigsberg, vice president of investment and tax solutions at Fidelity. Here's why. Generally, pre-tax contributions to a traditional IRA can help lower your taxable income, if you are eligible, giving you more money in your pocket. These tax savings help improve your retirement picture only if you're disciplined enough to save. If you tend to spend any money left at the end of the month, or any income tax refund, it's not going to help your bottom line when you retire. Of course, on the other hand, the tax savings may provide an extra incentive to save now that Roth IRAs don't offer.
With Roth IRA contributions, you pay taxes up front. But if you (like many people) tend to spend all your discretionary income, having less disposable income might be a good thing when it comes to your retirement savings.
"In a sense," says Kenigsberg, "switching from a traditional IRA to a Roth IRA forces you to save more for later by keeping less in your pocket now, assuming you keep making the same contribution."
Roth IRAs have additional advantages that go beyond taxes. Because you don't need to take RMDs with a Roth (during the life of the original owner) and because the assets in a Roth account can be bequeathed to your heirs income tax-free, Roth accounts can be a useful estate planning tool.
Not eligible to contribute to a Roth IRA because your income is too high? You can convert a traditional IRA to a Roth IRA, though you will need to pay taxes on the conversion. (If you've made nonqualified contributions and include them in your converted balance, they won't be taxed.)
For a detailed look at tax-smart conversion strategies, read Viewpoints on Fidelity.com: Tax-savvy Roth IRA conversions.
Having it both ways
It may be appropriate to contribute to both a traditional and a Roth IRA—if you can. Doing so will give you taxable and tax-free withdrawal options in retirement. Financial planners call this tax diversification, and it's generally a smart strategy when you're unsure what your tax picture will look like in retirement. (Remember, though, you can contribute only up to the contribution limit in any one year—so $5,500 in 2018, $6,000 in 2019, plus $1,000 if you are age 50 or older—in total across all IRAs you own, whether traditional or Roth.)
For example, with a combination of traditional and Roth IRA savings, you could take distributions from your traditional IRA until you reach the top of your income tax bracket, and then withdraw whatever you need beyond that amount from a Roth IRA, which is tax-free, provided certain conditions are met.
On the other hand, taxes in retirement may not be the whole story. Reducing your current taxable income through traditional IRA contributions may also be advantageous for other reasons, such as qualifying for student financial aid.
There's still one more tax benefit available to some taxpayers: the saver's credit. The maximum credit available is $2,000. Eligibility is based on your adjusted gross income (AGI). Depending on your AGI, you could get a credit of up to 50% of your contribution to an IRA or workplace retirement plan. The amount of the credit goes down as income goes up, phasing out at $64,000 for joint filers.
Investing an IRA contribution
Many people make their IRA contribution just before the April tax deadline, and put it into a money market fund. Then they never go back and choose a growth-oriented investment. This is generally not ideal. One of the best ways to give the money a chance to grow over the long term is by having an age-appropriate level of diversified exposure to stocks—in the form of mutual funds, ETFs, and/or individual securities. Of course, that means getting used to riding the ups and downs of the market.
Consider this hypothetical projection: One $5,500 contribution could grow to almost $59,000 in 35 years. For those age 50 or older, one $6,500 yearly contribution could grow to more than $69,000 in 35 years.5 (We used a hypothetical 7% long-term compounded annual rate of return and assumed the money stays invested the entire time. Investments that have the potential to return 7% annually are generally those that come with some risk, such as stocks.)
If the $5,500 amount seems daunting, even if you can put only $550 into an IRA and leave it there invested for 35 years, earning a hypothetical annual return of 7%, it could be worth nearly $5,900 in 35 years. Make that $550 contribution every year and it could be worth over $81,000 after 35 years, using a hypothetical annual rate of return of 7%. (Note: These examples do not take into account taxes, inflation, or fees.)
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