Tax-Free or Tax-Deferred Retirement Savings? Roth IRAs vs. Traditional IRAs

Tax-Free or Tax-Deferred Retirement Savings? Roth IRAs vs. Traditional IRAs

July 23, 2020
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Roth IRAs and traditional IRAs are popular individual retirement arrangements that have similar and different benefits. Traditional IRAs offer tax-deferred savings. Roth IRAs offer tax-free growth and tax-free distributions provided certain conditions are met. The main question to consider is do you want a tax break now or would you prefer to reap the benefits of tax-free distributions when you retire?

Both Roth IRAs and traditional IRAs allow you to make annual contributions of your earned income. The contribution limits for each plan in 2020 are the same: $6,000 (plus $1,000 if you’re 50 or older).  Since the SECURE Act was passed, you can continue contributing to a traditional IRA after the age of 70 ½ —as long as you’re still working. (This was always the case with a Roth.)

Traditional IRAs

  • Contributions are made with pre-tax income.
  • You can make tax-deductible contributions if you are eligible.
  • Earnings grow tax-deferred; you pay tax when you take distributions in retirement.
  • Required minimum distributions (RMDs) start at age 72 (for those who turned 70 ½ after December 31, 2019).
  • Early withdrawals before age 59 ½ are charged a 10 percent penalty on top of tax.

While there are no income limitations to use these plans, there are restrictions on your contributions being tax deductible.

If you and/or your spouse are not active participants in a workplace plan, your contributions to a traditional IRA are 100 percent deductible.

But, if you or your spouse are participating in workplace plans, the following restrictions apply.

Requirements for Tax-Deductible Contributions to Traditional IRAs

If you are an active participant in an employer-sponsored plan:

Single or head of household and you participate in a workplace plan:

  • If your modified adjusted gross income (MAGI) is $65,000 or less, your full contribution is tax deductible.
  • If your MAGI is over $65,000 and less than $75,000, your contribution is partially deductible.
  • If your MAGI is $75,000 or more, you cannot deduct any portion of your contribution.

Married filing jointly or a widower and you participate in a workplace plan:

  • If your MAGI is $104,000 or less your entire contribution is deductible.
  • If your MAGI is more than $104,000 but less than $124,000 your contribution is partially deductible.
  • If your MAGI is $124,000 or more, your contribution is not tax deductible.

If you are married filing separately and you participate in a workplace plan:

  • If your MAGI is less than $10,000 your contribution is partially deductible.
  • If your MAGI is $10,000 or more, you can’t deduct any portion of your contribution.

If your spouse participates in a workplace plan:

Married filing jointly and spouse participates in workplace plan:

  • If your MAGI is $196,000 or less your whole contribution is deductible.
  • if your MAGI is greater than $196,000 but less than $206,000 your contribution is partially deductible.
  • if your MAGI is $206,000 or more, your contribution is not deductible.

Married filing separately with a spouse who participates in a workplace plan:

  • If your MAGI is less than $10,000 the entire contribution is deductible.
  • If your MAGI is $10,000 or more, you cannot deduct your contribution.

Roth IRAs

  • Contributions are made with post-tax income.
  • Contributions are not tax deductible, but your distributions of income earned in the account are tax-free when you retire.
  • You don’t have to take RMDs at 72 like you do with traditional IRAs.
  • Early withdrawals are not taxed or penalized if you have owned the account for 5 years and are over the age of 59 ½.
  • You are never taxed on withdrawals of contributions you made to the account.

A Roth can provide children a unique way to save for college and retirement at the same time. Since you aren’t taxed on withdrawals of contributions, you can withdraw those funds regardless of your age, how long you owned the account, and for any reason you wish. Qualified distributions of earnings are tax free, as well.

An added bonus of the Roth IRA is that your beneficiaries aren’t taxed on distributions from the account, either. This is a key benefit since the period of time to deplete a non-spousal IRA has been reduced to 10 years instead of spread out over the life expectancy of the beneficiary.

Income Requirements for Roth IRAs

It may appear that Roth IRAs are the preferred plan. But, not everyone can use a Roth IRA to invest for retirement. Your eligibility depends on your income tax filing status and how much money you make:

  • For couples married filing jointly: You must have a modified adjusted gross income (MAGI) that’s less than $206,000 to contribute to a Roth IRA.
  • For single/head of household filers: You’re not eligible to use Roth IRAs if your MAGI is over $139,000.

To Summarize Roth IRAs vs. Traditional IRAs

Roth IRAs may indeed be the preferred plan if you meet the eligibility requirements. Most people enjoy the flexibility these accounts offer, and the ability to make tax-free withdrawals of income in the plan when they retire. However, traditional IRAs can help you relieve your tax burden today by allowing you to make contributions on pre-tax income as well as the ability to make tax-deductible contributions, if you meet the qualifications. As always, the choice is yours but hopefully the elements in this article make the differences between Roth IRAs and traditional IRAs clear so your decision is an easy one.

 

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.