Retirement can be very exciting. With time and freedom, you can finally finish that novel, pick up pottery, or explore Eastern Europe. The quality of your retirement depends on how you save and invest when you are younger. Saving for the perfect retirement takes time and foresight. Some of the most popular and tax-efficient retirement savings tools are IRAs. These accounts boost your retirement savings by giving you tax deferral and reduction. If you are not familiar with IRAs, this article is perfect for you to learn everything you need to know to boost your retirement savings in 2020.
What’s an IRA
An Individual Retirement Arrangement (IRA) is a retirement account in the U.S. that you can use to invest in stocks, bonds, and mutual funds for your retirement, just like a regular investment account. The IRA is offered by the U.S. government to help people save for their retirement. Canada has a similar retirement savings plan – the Registered Retirement Savings Plan (RRSP).
What sets IRAs apart from other investment and savings accounts is that they offer impressive tax savings that will boost your overall return. A traditional IRA allows savers to invest with pre-tax dollars and defer all tax obligations to when you withdraw from the account. A Roth IRA, on the other hand, requires after-tax dollars but all the incomes and capital gains from your investments are tax-free!
Each IRA has two phases: the contribution phase and the distribution phase. The contribution phase is when you regularly save money into your account. Once you reach retirement and start taking money out of your IRA, the distribution phase starts.
Who can benefit from an IRA?
The short answer is everyone!
If you have an employer-sponsored retirement plan like a 401K, you can use an IRA to continue investing after maxing out your 401k contributions. Compared to a 401k, IRAs allow the savers to manage their own investment with a lot more flexibility. Most 401k plans only give you the option to invest in mutual funds. With IRAs, you can invest your savings in almost anything: stocks, bonds, mutual funds, ETFs, and even cryptocurrencies.
If you don’t have any retirement plan or just got your first job, you have the most to gain from opening an IRA. Having a retirement savings account gives you the right tool to invest and secure your financial future.
What are my options?
There are two types of IRA accounts: Traditional IRA and Roth IRA. Both offer great retirement savings options with different eligibility and tax benefits. As an investor, you can choose one or both. However, the government limits the combined contribution to both types of IRAs to be $6,000 each year. This limit is raised to $7,000 for people 50 and older. As long as you are within the limit, you have complete freedom to contribute to either account.
Traditional IRA
Benefits
A traditional IRA has two types of tax benefits for retirement savers. First, the monthly contribution to a traditional IRA is tax-deductible. The tax deduction allows you to not pay any income tax on the money you put into your traditional IRA account. Depending on your income bracket, this benefit translates into a 22% tax saving on average.
Additionally, all earnings from a traditional IRA are tax-deferred. As long as the investment and earnings stay in your account, you don’t need to pay any income or capital gain taxes. The full amount of your earnings can be reinvested into the market without the government taking a cut. On the contrary, income and dividends are taxed each year in a regular investment account.
For a traditional IRA account, you only pay taxes on your investment when you reach retirement. When you start taking money out of the account, your withdrawal will be taxed as ordinary income based on your tax bracket.
Eligibility
Contribution to a traditional IRA is not limited by your income level or your other retirement plans. However, the tax deduction benefit does depend on these factors.
If you do not have an employer-sponsored retirement plan like a 401k, you can deduct the whole contribution to your traditional IRA from your taxable income for tax reporting. With an employer-sponsored retirement plan, your deduction cap will change based on your income. For single savers making less than $64,000 (Modified Adjusted Gross Income) a year, they can deduct the whole amount from their tax return. As your income grows, the deduction gradually phases out. In 2020, single individuals making over $75,000(MAGI) each year cannot claim any tax deduction for their traditional IRAs.
Distribution
Distributions from traditional IRAs are taxed as ordinary income at the time of withdrawal. You can take distributions from your IRA account as soon as you turn 59.5. When you reach 70.5, you must take the Required Minimum Distribution(RMD) each month. The RMD depends on your account balance and your age.
Roth IRA
Benefits
In a Roth IRA, contributions to the account have to be made with post-tax dollars. This is different from the traditional IRA. However, when you reach retirement and start withdrawing, you pay zero in taxes on any earnings, incomes, or capital gains. This means that investments in a Roth IRA grow completely and wonderfully tax-free.
Eligibility
The allowed contribution limit for a Roth IRA depends on your income level. In 2020, single investors with income less than $124,000 (MAGI) can contribute up to 6,000 to their accounts ($7,000 if you are 50 or older). This limit decreases gradually and completely phases out if your income exceeds $139,000 (MAGI).
Distribution
You can withdraw money from your Roth IRA when you reach 59.5 and if your account is at least 5-year-old. There is no mandatory distribution. You can keep your money in your Roth IRA as long as you want.
Comparing traditional IRA and Roth IRA
Traditional and Roth IRA have many minor differences. To help you understand them better, we compiled the important differences in the table below.
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contribution Limit | Not affected by income | Decrease with higher income |
| Contribution Deduction | Fully deductible if the saver has no employer-sponsored retirement plans. Otherwise, deduction decreases with higher income | NA |
| Taxes on Income and Dividends | Tax-deferred until withdrawal | Tax-free |
| Minimum Age for Withdrawal | 59.5 | 59.5 and account must be 5-year-old |
| Early Withdrawal Penalty | 10% penalty + taxes if withdrawn before 59.5 | No penalty when you withdraw your original contribution. Earnings withdrawal is subject to potential penalties and taxes |
| Required Distribution | Must start distribution at 70.5 | No mandatory distribution |
| Contribution Age Limit | No more contribution after reaching 70 | No Limit |
Do I qualify for a traditional IRA or a Roth IRA?
Traditional IRA
You always qualify for a traditional IRA account regardless of your income level or participation in other retirement plans. However, the tax deduction benefit varies. If you don’t have an employer-sponsored plan, you can deduct your whole contribution from your taxable income.
If you have an employer-sponsored plan, your deduction will change based on your income. Remember, even if your contributions are not deductible, your earnings can still grow tax-deferred in a traditional IRA. That is nonetheless a good benefit to take advantage of.
| If Your Filing Status Is... | And Your Modified AGI Is... | Then You Can Take... |
|---|---|---|
| single or | $65,000 or less | a full deduction up to the amount of your contribution limit. |
| head of household | more than $65,000 but less than $75,000 | a partial deduction. |
| $75,000 or more | no deduction. | |
| married filing jointly or qualifying widow(er) | $104,000 or less | a full deduction up to the amount of your contribution limit. |
| more than $104,000 but less than $124,000 | a partial deduction. | |
| $124,000 or more | no deduction. | |
| married filing separately | less than $10,000 | a partial deduction. |
| $10,000 or more | no deduction. | |
| If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the "single" filing status. |
As mentioned before, you can have a traditional IRA or a Roth IRA at the same time. For each saver, the maximum annual contribution applies to the sum of both traditional IRA and Roth IRA. If you are under 50, your total annual contribution allowance is $6,000. This allowance is raised to $7,000 for people 50 and above.
Roth IRA
Participation in employer-sponsored retirement plans does not affect your Roth IRA contributions. But with a higher income, your contribution limit decreases.
| If your filing status is... | And your modified AGI is... | Then you can contribute... |
|---|---|---|
| married filing jointly or qualifying widow(er) | < $196,000 | up to the limit |
| > $196,000 but < $206,000 | a reduced amount | |
| > $206,000 | zero | |
| married filing separately and you lived with your spouse at any time during the year | < $10,000 | a reduced amount |
| > $10,000 | zero | |
| single, head of household, or married filing separately and you did not live with your spouse at any time during the year | < $124,000 | up to the limit |
| > $124,000 but < $139,000 | a reduced amount | |
| > $139,000 | zero | |
Which IRA is better for me?
IRAs are amazing tools to boost your retirement savings. You might wonder which IRA works best for you. Sometimes, your income and participation in employer-sponsored retirement plans might restrict your choice for an IRA. For example, if you have a high income, Roth IRA might not be available to you. And having a 401k at work will affect your tax reduction in a traditional IRA.
If you qualify for the full tax deduction and Roth IRA contribution, then you have a choice to make. The major difference between a traditional IRA and a Roth IRA lies in when you pay taxes. For traditional IRAs, you don’t pay any income tax on your contributions but the tax is due when you withdraw from your account. For Roth IRAs, your contributions are taxed but your distributions are tax-free.
Consequently, the first consideration for choosing an IRA is your current and future predicted tax bracket. If you expect to have a lower tax bracket during retirement, a traditional IRA allows you to defer tax payment later to avoid a higher tax rate. If you anticipate that you will be in a higher tax bracket when you withdraw, a Roth IRA will be more beneficial.
Unfortunately, predicting one’s future income is difficult. A recommended practice is to diversify. Some investors use the Roth IRA and traditional IRA at the same time. This strategy gives you a lot of flexibility. As your income changes, you can change the ratio of Roth and traditional IRA contributions. Having both accounts also gives you more flexibility in distribution. When you retire, you can withdraw from the Roth IRA during years with high incomes. When your income is low, you can withdraw from the traditional IRA first.
Flexibility
Between the two choices, Roth IRAs have more flexibility for both contribution and distribution. For example, if you need to access the fund in your retirement account, a Roth IRA allows you to withdraw your original contributions without penalty. This can be handy during an emergency. However, you will face taxes and a 10% penalty when you withdraw from your traditional IRA account before you reach 59.5. Additionally, a Roth IRA does not have mandatory distribution. You can keep the money growing in your account if you don’t need to withdraw. Lastly, you can contribute to your Roth IRA at any age but contributions to a traditional IRA are only accepted before you reach 70.5.
Summary
A fulfilling retirement requires diligent saving, smart investing, and foresight. To prepare for a great financial future, each dollar saved goes a long way. You should take advantage of the great tax benefits of IRAs. Although choosing between a traditional IRA and a Roth IRA can seem complicated, the Internal Revenue Service (IRS) allows re-characterization of your IRA accounts. You can always make a switch if the result is less than perfect. Our advice is to not let this decision stop you from taking action. Treat the new year as an opportunity to start saving for your retirement and let the IRAs help you achieve your goals.
