Understanding the Tax Benefits of Traditional & Roth IRAs
In addition to saving for retirement, one of the main incentives for saving in an IRA is being able to take a tax-deduction each year a contribution is made – at least for a Traditional IRA. At one time, that was your only option. But today, you also have the option of contributing to a Roth IRA instead of or in addition to a Traditional IRA. Roth IRA contributions are not tax-deductible but offer a significant tax benefit in retirement.
To decide which type of IRA might benefit you from a tax perspective, you’ll need to decide whether you want to pay the tax on the money you’re contributing now, at today’s rates, or when you retire. The answer depends on several factors including your income, tax bracket, age, and the tax status of your other retirement savings. You might want to see a tax advisor to help you evaluate the benefits of each type of IRA for your situation. In the meantime, here’s a reminder of the tax benefits available with a Traditional IRA and a Roth IRA.
Many IRA owners qualify to take a tax deduction for their annual IRA contribution. This tax deduction gives you the benefit today of not having to pay tax on the earned income that you put into a Traditional IRA. You get to defer the tax owed on your contribution until you withdraw it from your IRA. You also get to defer paying tax on any investment earnings that accrue in your Traditional IRA.
Income Limits for Deducting a Traditional IRA Contribution
Traditional IRA contributions are fully deductible unless you or your spouse are covered by an employer’s retirement plan, such as a 401(k) plan. If you or your spouse are participating in a workplace plan, your modified adjusted gross income (MAGI) must be under a certain threshold to deduct your Traditional IRA contribution. For example, the maximum MAGI a married couple may earn in 2020 and still take a partial deduction for a Traditional IRA contribution is $124,000. A different limit ($206,000) applies if you are not participating in a retirement plan but your spouse is. (See the IRS website for all limits.)
When you take money out of your Traditional IRA, you generally must include the entire distribution amount in your taxable income for that year. If you were unable to take a deduction for any of your contributions over the years, or you rolled over after-tax money from an employer plan into your Traditional IRA, your withdrawal may be only partially taxable. Each Traditional IRA distribution is considered a pro rata return of (1) nondeductible contributions and after-tax assets (called basis), (2) deductible contributions, and (3) earnings. The basis portion of the distribution is tax-free; the rest is taxable. The IRS views all your Traditional, SEP and SIMPLE IRAs in aggregate when determining the taxable portion of a distribution from one of these types of IRAs.
Paying taxes when you take money out of your IRA may benefit you if you were in a higher tax bracket before you retired. Additionally, reducing your taxable income during your earning years with the tax deductions may be more beneficial to you than avoiding taxation in retirement when your income and tax rates could be lower. On the flip side, however, if tax rates are higher in future years, you may appreciate the tax advantages of a Roth IRA instead.
Unlike Traditional IRA contributions, Roth IRA contributions are never deductible. And Roth IRA owners (and their spouses) must have earned income below a certain level to be eligible to contribute to a Roth IRA. For example, married individuals with MAGI over $206,000 are not eligible to contribute to a Roth IRA. (See the IRS website.)
All contributions are made with after-tax dollars, so there is no up-front tax benefit to contributing to a Roth IRA, but you don’t pay any tax on investment earnings while your savings are in the Roth IRA. The primary tax benefit for a Roth IRA occurs at the time you take money out. If you take a “qualified” distribution, it will be entirely tax free, including the investment earnings, for which you haven’t paid any tax. Tax-free investment earnings are attractive for IRA owners who have a long time to grow their IRA investments. For your Roth IRA distribution to be qualified, you must meet two requirements:
1. Five years must have passed since your first contribution to a Roth IRA.
2. You must have turned age 59½, died, became disabled, or made a first-time home purchase (that qualifies for an exception to the 10% early distribution tax).
If you do not meet both requirements, your Roth IRA distribution is not qualified and the earnings portion of a distribution must be included in your taxable income. However, your Roth contributions will always be distributed tax free, and they are deemed to come out first when you withdraw money from your Roth IRA. The earnings in your Roth IRA are considered the last to be distributed, giving you more time to meet those qualified distribution requirements for tax-free earnings.
Individuals who believe they will have higher earnings and be in a higher income tax bracket in the future as compared to today may choose to pay taxes now at the lower rates and invest in a Roth IRA. And some individuals choose to save in a Roth IRA to ensure they have a tax-free source of income in retirement.
Diversifying your retirement savings from a tax perspective can be just as important to your retirement savings strategy as diversifying your investments. You may choose to contribute to just one type of IRA, or you may choose to contribute to both. Just remember that the maximum annual contribution limit ($6,000 for 2020) applies in aggregate to your Traditional and Roth IRAs. If you are age 50 or over, you may also make an additional catch-up contribution of up to $1,000 each year.
Disclaimer: The information provided herein does not, and is not intended to, constitute personalized financial or legal advice. The contents of the article are for general informational purposes only and should not be relied or acted upon without specific professional legal or financial advice, based upon an individual’s situation.