Traditional and Roth IRA Basics

Individual Retirement Accounts (IRAs) are a cornerstone of retirement planning for people who don’t have employer-sponsored plans, but did you know that many people with a 401(k), 403(b), or Thrift Savings Plan (TSP) are also eligible to contribute? 

If you’ve been thinking about boosting your savings, an IRA could be the perfect way to turbo-charge your retirement plan. Best of all, there’s still time to take advantage of those tax benefits for 2020 if you haven’t filed yet. Here’s everything you need to know about these tax-advantaged accounts. 

Traditional IRA 101

A traditional IRA is a savings plan that allows you to build a retirement nest egg without paying taxes on dividends, interest, and other earnings. This means your wealth can grow more quickly than in a standard brokerage account, which is subject to capital gains taxes each year. This is a big benefit designed to encourage people to save for retirement in a world where pensions are no longer available for most workers.

Even better, your contributions to a traditional IRA are tax-deferred, which means you do not have to pay taxes on the money you contribute. When you file your taxes, you can deduct the amount of your contributions from your taxable income, which will lower your tax burden for the year. You will, however, pay taxes on distributions you take from your traditional IRA once you retire.

You may begin distributions without penalty at age 59½; you must begin to take required minimum distributions by age 72.  

Roth IRA 101

A Roth IRA is another type of retirement account with important tax advantages. Like a traditional IRA, the earnings on stocks, bonds, and other investments in the account are not taxed, which helps you build wealth at a much faster clip. 

What makes a Roth IRA different is that you pay taxes on your contributions upfront, in the year you earn the money. However, you will never pay taxes on that money again, so when you retire, your distributions are tax-free. With good planning, a Roth IRA can help reduce your tax burden in retirement and make your savings go farther.

Roth IRAs come with a few additional advantages. Because you already paid taxes on your contributions, you can take out what you put in at any time — the only penalty comes for taking out earnings before age 59½. There are also no required minimum distributions, so you can pass on your Roth IRA to your heirs when you die.   

Contribution Rules

With such great benefits, it’s no surprise that there are contribution limits to both traditional and Roth IRAs. For the years 2020 and 2021, the contribution limit for both traditional and Roth IRAs is $6,000 per year. Once you turn 50, you can contribute $7,000 annually.

Note that Roth IRAs have an additional phase-out of eligibility based on income. In 2020, single filers with a modified adjusted gross income between $124,000 and $139,000 will have a reduced contribution amount, and those with a MAGI over $139,000 are not eligible to contribute. For married joint filers, contributions are reduced for those with a MAGI between $196,000 and $206,000. Those with a MAGI over $206,000 are ineligible.

You can make contributions to either type of IRA right up until the tax filing deadline for that year. This means that people with a traditional IRA can make a final contribution as they calculate their taxes, allowing them to lower their taxable income at that last minute if they haven’t maxed out their contributions. This is especially handy if you’re close to crossing into the next tax bracket and want to stay below the threshold.

Who Can Contribute to an IRA?

Anyone with earned income can contribute to an IRA. This includes teens with babysitting jobs, the self-employed, and anyone working a side gig for extra income. It should be noted, however, that Social Security checks and pension payments are not considered earned income, so you’ll need to take on at least a part-time or seasonal job to contribute if you retire early. 

You can also contribute to an IRA if you already have an employer-sponsored 401(k) or TSP but there are some caveats when it comes to deducting your IRA contributions if you participate in both plans. It is always best to consult with a tax advisor. However, this can be a good way to diversify your investments by having both a traditional and Roth-style plan, which lets you ease some of your tax burden both now and in retirement.

Finally, a non-working spouse can also have an IRA. The Spousal IRA is the exception to the rule about needing earned income and allows the working spouse to contribute to an account on the non-working spouse’s behalf. The Spousal IRA is in only one person’s name and is not a joint account.

Extra Credit: The Backdoor Roth

If you are a high earner whose MAGI is above the limit for Roth IRA contributions, there’s still a way to contribute to a Roth each year. This strategy is known as the “backdoor Roth IRA.” This is not a special account, but rather refers to converting money from a traditional IRA or 401(k) into a Roth. Because there are no income limits on traditional IRAs, you can contribute up to $6,000 in that account, then convert it into a Roth any time you wish.

Be aware that when you rollover money into a Roth, you are taxed on that money in the year of the rollover. This means that you should work with a professional to calculate your taxes and make sure that you don’t convert more than you can afford to pay the taxes on in any given year. You’ll also need to wait at least five years before being able to withdraw these converted funds.

Despite the immediate taxes, a backdoor Roth can be a valuable strategy if you’re looking to reduce future taxes during retirement, especially if you think you may be earning much more then — or you’re betting that taxes will go up. It’s also a way to avoid required minimum distributions on some or all of your retirement nest egg to keep your wealth intact for yourself and your heirs.

The Bottom Line

If you haven’t maxed out your IRA contributions for 2020, there’s still time! This year, you have until May 17 to file your taxes and complete any 2020 IRA contributions. And if you don’t have an IRA, now is the perfect time to get started — we can help! Contact us today to make sure your 2020 contributions are made in time.