An IRA is a type of account that allows individuals to save for retirement with tax benefits. There are several types of IRAs available, including Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each has its own unique features and eligibility requirements.
Except for Traditional and Roth IRA’s, the rest are typically used by small businesses or the self- employed. So, we will be focusing on the two types most used, and I’ll address the other types in a future article.
If you are in a rush, I have included a handy chart below that covers the most common differences between Traditional and Roth IRA’s.
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Make sure we have earned income. So, what does that mean? With only a few exceptions, you cannot contribute to an IRA if you do not have some source of income that is paid for work performed. The IRS defines earned income as:
wages, salaries, tips, union strike benefits, net earnings from self-employment and long-term disability benefits received prior to minimum retirement age.
Decide how much. The maximum you can put in an IRA for 2023 is $6,500. If you are 50+ there is a “catch up” provision that allows you to invest an additional $1,000 for a total $7,500. You can decide to break up this amount however you like. You can make an annual contribution, monthly, weekly, whatever you like.
Decide how you want to invest your new IRA funds. Think of an IRA as a shoebox where you store lots of different things… An IRA is not an investment in and of itself. It is a designation that is assigned to your account. You can have several different account types listed as your IRA.
However, you can’t hold:
It is also worth noting, your IRA must be funded with currency aka cash. You cannot transfer property or investments from a non- retirement account into an IRA.
In a nutshell, a Traditional IRA is an account that allows you to deposit part of your income, which is then deducted from your taxable income, and is allowed to grow tax deferred, provided you do not withdrawal the funds unless:
This is just a few of the most common exceptions. You can get detailed information here: Exceptions to Tax on Early Distributions. You should also consult your financial advisor and/ or tax professional prior to withdrawing funds.
If you don’t meet one of the above exceptions, any funds taken out of the IRA will be added to your Adjusted Gross Income, and you will have to pay income tax on the funds. You will also be hit with an additional 10% penalty. If that isn’t bad enough, since the withdrawal is added to your AGI, it may push you into a higher tax bracket.
…a little history
In 1974 the US Congress passed a law creating the Individual Retirement Account (IRA), or what is now referred to as a Traditional IRA. This was to encourage workers who did not have access to an employer-sponsored retirement plan to save for retirement, and not solely depend on social security. It also allowed employees to roll over their employer sponsored plan into an outside account and retain the tax advantages. If you’re a dork, like me, you can read all account it in this Congressional Report: Individual Retirement Account (IRA) Ownership: Data and Policy Issues.
The biggest difference between a Traditional IRA and a Roth IRA is when you pay taxes. The money you deposit in a Roth IRA is post-tax money. The idea is you earn income, pay taxes at today’s rate, let the funds grow in the Roth IRA and withdrawal your initial contributions plus any earning without owning any further taxes.
To receive the favorable tax treatment, the funds must be in the account for at least five years, and you must be 59 ½ or older. Roth IRA’s share the same withdrawal exceptions as their Traditional counterpart…with one exception- You can withdrawal your contributions to a Roth at any time, without a penalty, provided you do not withdrawal any of the earnings.
Contributions are limited by your income.
Once your income reaches a certain point, the amount you can contribute, and deduct from your earned income is phased out:
The traditional IRA phase-out ranges for 2023 are:
Trad IRA 2023 Deduction Limits for Covered Employees
The phase-out ranges for Roth IRAs are:
IRS Roth IRA Contribution Limit Chart for 2023
If you are:
The younger you are, or the earlier you are in your career, the greater the chance your income is going to increase, meaning your will be in a higher tax bracket in later years.
This perfect scenario allows you to maximize the amount you can save for retirement and give you two pools of money to strategize your future withdrawals and lessen your tax burden.
There are only two situations where a Traditional IRA would benefit you over a Roth IRA
If you are on the border of two tax brackets, and you can save for retirement and knock yourself into a lower tax bracket that is a win- win.
This one speaks for itself. If you are in a higher tax bracket now, while you are working, and your situation means you will bring home less in retirement, it doesn’t make sense to invest in a post- tax retirement account. You might as well wait and pay the taxes when you’re in a lower tax bracket. But there is one caveat… who can predict future tax brackets! Nobody knows for sure, so it certainly something to keep in mind.
Thanks, you’ve talked me into a Roth IRA… But my income is too high! No problem. This is where the Backdoor Roth IRA comes in.
Once funds are invested in an IRA, a Traditional IRA, those funds can be rolled over into a Roth IRA. Keep in mind, this is a taxable event… which means you will have to pay income tax on the converted funds, but there is no penalty, and you then get all the benefits of the Roth IRA.
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