The IRA is one of the most important retirement investment vehicles for future retirees to understand.
Millennials, and even Gen-Xers to some extent, may think that understanding the IRA now isn’t completely necessary, as the thought of retirement may not even be on the horizon. However, we can’t stress enough the importance of knowing how to utilize these accounts to provide flexibility and financial security, to any individual or family, right now. Correctly utilizing IRA rules along with knowledge of other tax-advantaged accounts can even be the key to early retirement:
This article will detail everything you need to know about IRAs, including their history, the differences in types of IRAs, and directions on how to easily set one up.
A Brief History of the IRA
Back in 1974, a year which saw the Watergate scandal, the Sears Tower construction completion, and the release of Blazing Saddles, another less-conspicuous thing happened: a law called the Employee Retirement Income Security Act of 1974 (ERISA) went into effect. Automaker Studebaker had shut the doors of its South Bend, Indiana plant, which caused thousands of employees to lose most, if not all, of their retirement savings that were within the Studebaker defined pension plan. Then, in the early 70s, a documentary showing the aftermath of the Studebaker failure lit a fire under legislators to create a solution.
Clearly, the focus of ERISA was around pension plans and how they were administered. The last thing voters wanted was to see a repeat of the Studebaker pension fiasco, and so the folks they elected to represent their interests acted. Among other things, this led to the creation of the Individual Retirement Account (IRA).
IRAs didn’t really become popular until 1981, when the Economic Recovery Tax Act (ERTA) was passed. This was because the original intent of the IRA was for it to be utilized only by people who were not already covered by an employment-based retirement plan. ERTA did away with that provision, causing the IRA floodgates to open.
The IRA (or traditional IRA as we now know it) cruised along for the better part of two decades as the de facto individual retirement account, until the passage of the Taxpayer Relief Act of 1997 (TRA). And with that, the Roth IRA, a modified version of the traditional IRA, was born.
Traditional vs Roth IRA
The Roth IRA has been the ‘sexy’ investment choice for younger generations since its inception. And there are some great reasons for this, especially for Millennial savers. The next section of this article will cover the differences in the Traditional vs Roth IRA, and include the following:
- Tax Deductibility of Contribution
- Income Limitations
- Withdrawal of Funds
- Taxation on Distribution
- Required Minimum Distribution (RMD) Rules
Before we go into the differences, a word on a couple major items that are the same between Traditional and Roth IRAs. First, at the time of this writing, the maximum yearly contribution is $5500 to either account (so long as the saver has met certain guidelines). Second, the contribution for a certain tax year can be completed all the way up until tax time (meaning you don’t have to rush to get your contribution made by the end of the calendar year).
Now, let’s move on to the differences in these accounts.
Difference #1: IRA Tax Deductibility
One main difference between Traditional and Roth IRAs is tax deductibility. With a Traditional IRA, the contribution can be pre-tax, meaning a saver may be able to deduct the contribution from her or his income for the tax year the contribution was made, so long as he or she didn’t make too much money. (We’ll get into income limitations in the following section).
Roth contribution, on the other hand, is always post-tax. This may sound like a disadvantage, but the Roth makes up for this with flexibility, which we’ll cover in Sections 3 and 4. In fact, for several reasons, it may be the ideal option for younger savers:
IRA Income Limitations
Both Traditional and Roth IRAs have their own distinct set of income limitations. First, we’ll go over the limitations for Traditional. We’ll cover the Roth second. An important note on this is that these limitations change every so often, and so the information below may become out of date. We’ll do our best to update this article if/when anything is modified.
Traditional IRA Income Limitations (2017)
We’re going to cover single and married filing jointly here for brevity purposes. We apologize if there is a scenario you’re curious about that isn’t covered below. If you have any questions about a specific circumstance, we recommend navigating to irs.gov or check out this table. Below limits are referring to Adjusted Gross Income.
- $62,000 or less- full deduction up to contribution limit ($5500 in 2017)
- >$62,000 but <$72,000- partial deduction
- >$72,000- no deduction
Married Filing Jointly:
- $99,000 or less- full deduction up to contribution limit
- >$99,000 but <$119,000- partial deduction
- >$119,000- no deduction
It’s important to note a couple things about the above info. First, if you have questions on the partial deduction calculation, we recommend consulting irs.gov. Second, if your AGI goes over and above the income limit, this doesn’t mean you can’t contribute to a Traditional IRA. It simply means that you can’t deduct the contribution from your AGI for that year. This is important for high earners, as the structure currently allows for something called a Backdoor Roth IRA. We’ll cover this later in the article.
Roth IRA Income Limitations (2017)
Again, we’re going to cover single and married filing jointly here for brevity purposes. We apologize if there is a scenario you’re curious about that isn’t covered below. If you have any questions about a specific circumstance, we recommend navigating to irs.gov or check out this table. Below limits are referring to Adjusted Gross Income.
- <$118,000- up to the limit ($5500 in 2017)
- Greater than or equal to $118,000 but < $133,000- reduced amount
- Greater than or equal to $133,000- cannot contribute directly to Roth IRA
Married Filing Jointly:
- <$186,000- up to the limit ($5500 in 2017)
- Greater than $186,000 but <$196,000- reduced amount
- Greater than or equal to $196,000- cannot contribute directly to Roth IRA
One final note on income limitations:
There is something called a ‘Catch-Up’ contribution. If a saver is 50 or older, that individual can contribute an additional $1000 annually as of this writing. So, the max contribution amount for someone in that age bracket is $6500 for 2017.
Withdrawal of Funds from IRA
There are significant differences regarding when a saver can remove funds from her or his IRA (also known as a distribution). We will first cover the Traditional IRA rules, then move to Roth.
Traditional IRA Distribution Rules
We covered that the traditional IRA allows for a deduction for the tax year in which the contribution was made, so long as the saver meets certain guidelines. So, in many cases, the money that is contributed to the traditional IRA has not been taxed. Not only will the money be taxed as ordinary income when a distribution is taken, the saver may also incur a penalty of 10% if the saver has not met the minimum age requirement.
At age 59 ½, the saver can begin taking distributions from the traditional IRA without penalty. This means that the money will be taxed according to whatever tax bracket the saver ends up being in for the year (see irs.gov for current tax brackets). This remains the same until age 70 ½, when the saver will have a Required Minimum Distribution.
One note on the traditional IRA
If the saver made too much money in a certain tax-year, but still wanted to contribute to a traditional IRA, then she/he would be able to do so. The saver would only be restricted as to the deductibility of the contribution. This means that the saver’s contribution would have already been taxed, and would allow him/her to withdraw this contribution tax and penalty-free.
Please note that if an IRA has both deductible and non-deductible funds, then the calculations/penalties can get somewhat complex. For more detailed information on this scenario, we recommend navigating to irs.gov.
Roth IRA Distribution Rules
Remember when we said the Roth made up for the non-tax-deductibility by being more flexible? This is what we were talking about.
Contributions to a Roth can be deducted by the saver at any time. However, if the saver takes a distribution of earnings before age 59 ½, she/he may need to pay an early-withdrawal penalty. Also, no minimum distributions are required for the Roth IRA owner until the owner’s death.
A Note on Roth IRA Withdrawals- Conversions
There is something called a “Backdoor Roth IRA” that is a strategy high earners use to contribute to a Roth. This strategy involves making non-deductible contributions to a Traditional IRA, then converting over to a Roth. The rules around when a saver can deduct these funds are a little more stringent than what was described above. We’ll go into this in our Bonus section (Backdoor Roth IRA).
IRA Taxation on Distribution
Uncle Sam will have his due. Basically, if contributions to the IRA haven’t yet been taxed, they will be upon distribution. There are extenuating circumstances, though- we recommend going to irs.gov to research these circumstances further.
Traditional IRA taxation upon distribution
Once the saver reaches the age of 59 ½, she/he can deduct funds from the Traditional IRA penalty-free. However, the money will be taxed as ordinary income.
Roth IRA taxation upon distribution
We’ve talked about how the owner of a Roth IRA can deduct her/his contributions at any time, as they’ve already been taxed. We also know that if the owner deducts earnings prior to age 59 ½, he/she would incur a 10% early-withdrawal penalty. What if the owner waits until after age 59 ½ to deduct earnings?
This is another area in which the Roth really shines. If the owner waits until after age 59 ½ to deduct earnings, she/he will not have to pay taxes on the moneys distributed.
IRA Required Minimum Distribution Rules
Required Minimum Distribution?! We know what you’re thinking… why am I required to do anything?
It’s my money!
Here’s something that may make everybody feel a bit better regarding this requirement. The design of the RMD rules prevents individuals from deferring taxation for their lifetimes, then bequeathing their accounts to heirs once they pass. Basically, the RMD rules make it more difficult to use IRAs as a vehicle to establish and/or continue a family dynasty. These rules actually favor the 99%!
Traditional IRA Required Minimum Distribution (RMD) Rules
Once the owner of a Traditional IRA reaches age 70 ½, he or she must begin taking Required Minimum Distributions. To boil it down, the minimum amount you’re required to take in the form of a distribution is calculated by dividing your remaining account balance by what’s called your Life Expectancy Factor. For more info, you can visit irs.gov or check out Vanguard's Life Expectancy Table.
But… what if I don’t take a Required Minimum Distribution?
The penalty for not following the rules on RMDs is hefty. If the owner fails to pay the RMD, she/he will be charged 50% of the amount that should’ve been paid (plus income tax, since this would’ve been taken from a pre-tax account). There are, of course, extenuating circumstances if someone has a legitimate reason for not taking the RMD- we would recommend reading up at irs.gov for more detail on this.
Roth IRA Required Minimum Distribution (RMD) Rules
This section will be rather short, because… there is no RMD for a Roth IRA until the owner of the account passes.
Traditional vs Roth IRA:
How Do I Remember the Differences?
If you came to this article wanting to learn about the differences between Traditional and Roth IRAs, we hope that the above descriptions helped you understand them. However, we know it’s difficult to remember all these, especially if this is your first time learning about these accounts. To remember the major differences, remember this acronym: TWITR:
- Tax Deductibility of Contribution
- Withdrawal of Funds
- Income Limitations
- Tax Consequences on Distributions
- Required Minimum Distributions
Now, if someone asks about the difference between these accounts- just remember- TWITR.
Backdoor Roth IRAs
We’ve mentioned the Backdoor Roth IRA several times in this article. This is because it’s one of the most important strategies for high earners to learn about. Read on to find out why many people swear by this strategy, and how to utilize this yourself.
As you saw in section 2 of this article (Income Limitations), if someone makes too much money, then she/he cannot directly contribute to a Roth IRA. However, setting up a Backdoor Roth is exactly like it sounds- utilizing the tax code so that high earners can essentially enjoy the same benefits as anyone else as it pertains to the Roth.
But why is it so important for high earners to learn this strategy?
Recall that, if an individual makes too much money, he/she cannot make a deductible contribution to a Traditional IRA. And again, that person may be ineligible to make a direct contribution to a Roth due to making too much. So, the only other option left to that person would be to make a non-deductible contribution to a Traditional IRA.
Is that so bad?
Well, not exactly. However, having deductible and non-deductible balances in traditional IRAs significantly complicates the taxation of distributions upon retirement. Also, as we discussed earlier in this article, traditional IRAs require a minimum distribution upon reaching age 70 ½, whereas the Roth IRA does not have an RMD rule.
So what are the steps?
High earners looking to take advantage of the backdoor Roth strategy set up a traditional IRA, make a non-deductible contribution, then convert this contribution over to their Roth. Her/his brokerage of choice generally can provide the owner with advice and documentation to make sure this transition occurs smoothly.
Why not just open a regular brokerage account?
The big advantage to this strategy over a typical taxable brokerage account is what we refer to as tax drag. Over time, your investments will most likely have taxable events, such as dividend payments or forced sales. This could cause the owner of the account to pay taxes each year on their investments, leaving him/her with less money. Having funds in a Roth avoids this issue.
A note about the Backdoor Roth and Traditional IRAs with both deductible and non-deductible balances
Be careful if you have both deductible and non-deductible traditional IRA balances. When you attempt to convert the non-deductible portion over to your Roth, things can get a little dicey from a tax perspective. We always recommend speaking with a financial advisor before making any money moves, including this one.
Which IRA is Best for Me?
There’s no easy answer to this question. However, here are some general tips regarding which account makes the most sense for which individual.
The Traditional IRA may make more sense for the mid-to-high earner who believes that her or his tax rate will be lower in the distribution phase.
The Roth IRA may make more sense for the individual who is just starting his or her career and is currently in a relatively low tax bracket.
The Backdoor Roth IRA strategy is for very high earners who cannot make a deductible contribution to a Traditional IRA or a direct contribution to a Roth IRA.
How Hard is it to Set Up an IRA?
Setting up the account is easy. You can set up your account through an online brokerage in a matter of minutes. One of our favorite providers is Scottrade, which allows customers to enroll in their Flexible Reinvestment Plan (FRIP). FRIP allows the account owner more flexibility in choosing which security she or he would like dividends to be reinvested.
Here are some additional resources that can provide further insight on personal finance matters:
- bogleheads.org -Great personal finance forum
- http://forum.mrmoneymustache.com/ - Another great personal finance forum
- https://personal.vanguard.com/us/insights/retirement/estimate-your-rmd-tool-Required Minimum Distribution Calculator
- https://www.scottrade.com/ -Scottrade, one of our favorite brokerages
- https://www.fool.com/retirement/index.aspx -Motley Fool, an excellent site with lots of great personal finance tips
- https://www.personalcapital.com/ -Our favorite budget/net worth tracking tool
We hope you enjoyed reading the Ultimate Guide to the Traditional vs Roth IRA. Our goal is to provide you with strategies that you can implement quickly and easily into your financial plan.
Do you have any insights on IRAs that weren't mentioned in this article? Please let us know in the comments below.
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The author of this article is not a licensed professional. This article and all information presented is for informational purposes only and should not be taken as financial or legal advice. We recommend our readers to consult with a licensed professional in the appropriate field prior to making any investment decisions.