Tax Benefits of a Traditional IRA vs ROTH IRA

An IRA is an individual retirement account, a vehicle people can use to save for retirement. Both Traditional and Roth IRAs have amazing tax benefits. Both types of IRAs help you with tax planning for retirement by giving you a vehicle to save money. The IRA that will be best for you will depend on your individual tax situation. These IRAs share many similarities with the main difference being how and when your money invested in the IRA is taxed.

Traditional IRA

If you want the tax break for the tax year currently being filed, if it is before April 15, the Traditional IRA provides you with a tax break now. Basically, a Traditional IRA allows you to invest pre-tax dollars into a retirement account, if you qualify. In other words, you do not have to pay federal or state income taxes on the money you invest in a Traditional IRA. If you use after-tax money to invest in a Traditional IRA, you will receive a tax deduction when you complete your taxes.

Since you take the tax advantage upfront, when you withdraw the funds in retirement, you will be taxed on the proceeds including the interest earned. If you are expecting to make more money during retirement and therefore be in a higher tax bracket, Traditional IRAs would not get you the most bang for your dollar.

Income Limits - Are you eligible to contribute to a Traditional IRA?

To be eligible to contribute to a Traditional IRA, you must have earned income, income you earn from work. You cannot contribute to a Traditional IRA more than you earned. However, a working spouse can contribute to a Traditional Spousal IRA for a nonworking spouse. Please note, you will not qualify for the tax deduction for contributing to a Traditional IRA if you earn above the threshold allowed for your filing status. The threshold established by the IRS is based on your modified adjusted gross income. This is your adjusted gross income (AGI) with some deductions added.

The income limits for Traditional IRA can be as low as the following, if you have a retirement plan at work. A qualified retirement plan includes a pension plan, 401(k), 403(b), SEP, SIMPLE, among others. For married filing separately filers, if you earn more than $10,000, you cannot take a tax deduction for contributions made to a Traditional IRA. For married filing jointly, the Traditional IRA deduction starts phasing out at $193,000 and completely phases out (no deduction allowed) at $203,000. For other taxpayers using the tax filing status of single, head of household, or married filing separately (if you didn’t live with your spouse during the tax year), the Traditional IRA deduction starts phasing out at $64,000 and completely phases out (no deduction allowed) at $74,000. If you do not have a qualified retirement plan at work, the income limits are higher. You can find them here.

If you do not qualify to take a deduction for contributions made to a Traditional IRA, you can still make nondeductible contributions to a Traditional IRA. You would just not qualify for the upfront tax benefit. However, you may qualify to contribute to a Roth IRA or a Backdoor Roth IRA discussed in more detail below, which would provide you with tax benefits later rather than none.

Roth IRA

With a Roth IRA, the tax benefits come later. Contributions you make to a Roth IRA are taxed. This means you do not get any tax savings for the money you deposit into a Roth IRA now. However, when you retire (after age 59½), as long as you have held the account for at least five (5) years, your distributions, including interest earned, will be tax-free. This means your money grows tax-free. It is working for you rather than the other way around. A huge tax benefit. Roth IRAs are a huge benefit if you expect to be in a larger tax bracket when you retire.

Another huge benefit to a Roth IRA is if you need your money, you can withdraw up to the amount you deposited without having to pay taxes or a penalty. After all, it is your money, and you already paid taxes on it. However, withdraws are discouraged. The money should be used for retirement. But, in the case of an emergency or in case you cannot wait any longer to buy that new car, you would have access to the money you contributed without penalty. It should be noted that your growth on the Roth IRA cannot be withdrawn tax-free until after you reach age 59½ and have held the account for the required time, just the money you deposited.

Income Limits - Are you eligible to contribute to a ROTH IRA?

To be eligible to contribute to a Roth IRA, you must have earned income, income you earn from work. You cannot contribute to a Roth IRA more than you earned. However, a working spouse can contribute to a Roth Spousal IRA for a nonworking spouse. Also, you cannot contribute to a Roth IRA if you earn above the threshold allowed by the IRS for your filing status. For married filing separately filers, if you earn more than $10,000, you cannot contribute to a Roth IRA. For married filing jointly, the Roth IRA contribution starts phasing out at $193,000 and completely phases out (no contribution allowed) at $203,000. For other taxpayers using the tax filing status of single, head of household, or married filing separately (if you didn’t live with your spouse during the tax year), the Roth IRA contribution starts phasing out at $122,000 and completely phases out (no contribution allowed) at $137,000.

If you earn too much money and you do not qualify to contribute to a Roth IRA, a retirement vehicle called a Backdoor Roth IRA provides a workaround. This allows high wage earners a vehicle to save for retirement that will provide tax benefits later.

Contribution Limits

The 2019 and 2020 contribution limits for both Roth and Traditional IRAs is a combined total of $6,000, if you are under age 50 ($7,000 if you are over 50 years old). This means if you contribute to both Roth and Traditional IRAs, you cannot contribute more than $6,000 (or $7,000 if over age 50) to both IRAs combined.

If you contribute too much money to either a Roth or Traditional IRA, you will have what the IRS considers an excess contribution. If you do not pull the money out before the tax filing deadline, you will owe a 6% penalty for each year the excessive funds are left in your IRA account.

The Bottom Line

It can be difficult to determine what your tax rate will be at retirement. Many tax planners recommend a combination of both ROTH and Traditional IRAs. This will give you the tax advantages of both rather than having to choose just one.

Although there are advantages for depositing money into your account earlier and throughout the year, one of the great benefits is that you have until the tax filing deadline, April 15, to adjust the amount you contributed or invest in a Roth or Traditional IRA. This gives you time to discuss with your accountant the tax advantages of contributing to either a Roth or Traditional IRA.

Understanding your IRA contribution limits and tax benefits can be confusing, contact the tax professionals at Gudorf Tax Group to schedule an appointment to complete your tax return and review your IRA contribution options.

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