At a glance
Tax season is here and you can still contribute for 2020, but you might be wondering where to put your contribution. When it comes to IRAs, there are 2 main types to choose from—Roth and traditional. Making that choice—and knowing when and how much you can contribute—isn’t always clear, so we want to provide some context around one of our most-commonly researched topics. Here’s more information on two retirement options: Roth IRAs and traditional IRAs.
A traditional IRA allows you to contribute money that can grow tax-deferred. A Roth IRA holds after-tax money you can withdraw tax-free. They sound fundamentally different, but both accounts are designed to help you save for retirement. They share other similarities too:
To better understand the differences between Roth and traditional IRAs, let’s focus on 3 areas: deductions, taxes, and withdrawals.
With a traditional IRA, you may be able to deduct your contributions (though the deductible amount could be reduced or eliminated if you or your spouse are covered by an employer’s retirement plan). When it’s time to start withdrawing, your deductible contributions and earnings are taxed as ordinary income. If you do not qualify for deductible contributions, you can make a nondeductible contribution; the nondeductible portion will not be taxed upon withdrawal. Withdrawals work like this:
Contributions you make to your Roth IRA aren’t deductible. This means withdrawals of your Roth contributions (your “basis”) will always come out tax- and penalty-free. Think of it like layers of a cake: When you take your first bite (or in this case, your first distribution), the topmost piece with the frosting is your basis. Beneath that layer? Your earnings. You can make tax-free withdrawals as long as you’re age 59½ or older and you’ve owned your Roth IRA for at least 5 years.* There are no mandatory withdrawals for a Roth IRA because your contributions have already been taxed—meaning you can withdraw your savings at your leisure in retirement.
Any individual with earned income (or who has a spouse with earned income) can contribute to a traditional IRA. However, the amount you can contribute to a Roth IRA could be reduced—or even eliminated—based on your modified adjusted gross income (MAGI).
If you can’t make the maximum Roth IRA contribution because your MAGI is nearing the upper limit of the annual income range, you may still be able to make the maximum IRA contribution (either $6,000 or $7,000, depending on your age) by splitting your contribution between a Roth IRA and a traditional IRA.
Whether you’re eligible to contribute to a Roth, a traditional, or both, opening this type of account is a step toward a better retirement. Your eligibility may depend on your income—so if you aren’t sure what to do, reach out to a tax advisor to help you make an informed decision.
*Withdrawals from a Roth IRA are tax-free if you’re age 59½ or older and have held the account for at least 5 years; withdrawals taken prior to 59½ or 5 years may be subject to ordinary income tax or a 10% penalty tax, or both. (A separate 5-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.) The 5-year holding period for Roth IRAs starts on the earlier of: (1) the date you first contributed directly to the Roth IRA, (2) the date you rolled over a Roth 401(k) or Roth 403(b) to the Roth IRA, or (3) the date you converted a traditional IRA to the Roth IRA. If you’re under age 59½ and you have one Roth IRA that holds proceeds from multiple conversions, you’re required to keep track of the 5-year holding period for each conversion separately.
All investing is subject to risk, including the possible loss of the money you invest.
We recommend that you consult a tax or financial advisor about your individual situation.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.