Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.
IRAs are one of the most powerful ways to save for retirement. And that’s important because only 23% of people are very confident they’ll have enough money in retirement.1 You may have heard the terms traditional IRA and Roth IRA, but what’s the difference? And which of them may be right for you?
You can save money through a traditional IRA as long as you have earned income for the calendar year that you declare to the IRS. The maximum contribution amount for 2019 is $6,000, but those age 50 and older are allowed to contribute up to $7,000.
You may be able to deduct all or part of your contribution to a traditional IRA depending on how much you earn. If neither you nor your spouse is covered by a retirement plan at work, you can deduct the full amount of your contribution. If either you or your spouse is covered by a retirement plan at work, then you may be limited to a partial deduction or no deduction at all (Figure 1).
Traditional IRA Deductibility Based on Income and Filing Status
|If your Filing Status Is...||And Your Modified Adjust Gross Income Is...||Then You Can Take...|
|Single or Head of Household||$64,000 or less||A full deduction up to the amount of your contribution limit|
|More than $64,000 but less than $74,000||A partial deduction|
|$74,000 or more||No deduction|
|Married Filing Jointly or Qualifying Widow(er)||$103,000 or less||A full deduction up to the amount of your contribution limit|
|More than $103,000 but less than $123,000||A partial deduction|
|$123,000 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.|
Source: IRS.gov, 2019
Traditional IRAs are intended to be a way to save for retirement, so the IRS assesses a 10% penalty if you withdraw money prior to age 59½ from a traditional IRA, and the amount you withdraw is added to your taxable income for the year. There are, however, a few exceptions that allow you to withdraw money prior to 59½ without incurring tax penalties:
- Unreimbursed medical expenses that exceed 10% of adjusted gross income
- A withdrawal of up to $10,000 for individuals ($20,000 for couples) for a first home purchase
- Withdrawals due to a documented disability
- Substantially equal payments under rule 72(t) that require withdrawals for the later of five years or until you age 59½
- College and vocational school costs such as tuition, fees, books, and supplies; room and board is also allowed if the student is at least a half-time student (Note: Although withdrawals are exempt from the 10% penalty, they’re considered taxable income and may impact financial aid)
The contribution limit for Roth IRAs in 2019 is the same as for traditional IRAs: $6,000 for people younger than 50 and $7,000 for those age 50 and older. In order to contribute, you need to meet the income thresholds illustrated in FIGURE 2.
Roth IRA Income Limits
|If your Filing Status Is...||And Your Modified Adjust Gross Income Is...||Then You Can Contribute...|
|Married filing jointly or qualifying widow(er)||< $193,000||Up to the limit|
|> $193,000 but < $203,000||A reduced amount|
|Married filing separately and you lived with your spouse at any time during the year||< $10,000||A reduced amount|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $122,000||Up to the limit|
|≥ $122,000 but < 137,000||A reduced amount|
Source: IRS.gov, 2019
While contributions to a traditional IRA are tax deductible subject to the income limits discussed above, contributions to a Roth IRA are funded with after-tax dollars and are not tax deductible. In exchange for forgoing that tax deduction now, your investment will grow tax-free.
For example, if you contribute $5,000 a year to an IRA beginning at age 40 for the next 25 years, you’d end up with more than $430,000 at age 65 assuming a hypothetical 8% annual growth rate. If you made this investment in a traditional IRA, any withdrawals you make on the $430,000 would be taxable income. By contrast, if you made this investment in a Roth IRA, you wouldn’t owe any taxes on the $430,000 when you begin taking withdrawals.
Another way to think of contributions to a Roth IRA vs. a traditional IRA is taxes now vs. taxes later. Would you rather get a tax deduction now for contributing to a traditional IRA and pay taxes on the money later when you begin making withdrawals? Or would you rather skip getting the tax deduction now with a Roth IRA so you don’t need to pay taxes later when your investment has hopefully grown significantly due to compounding?
Traditional IRA vs. Roth IRA: What’s the Difference?
|Traditional IRA||Roth IRA|
|Contribution Limit (2019)||$6,000; $7,000 for age 50 and older||$6,000; $7,000 or age 50 and older|
|Taxes||Tax deductible subject to income limits; investment grows tax-deferred||Funded with after-tax dollars (so not tax deductible); investment grows tax-free|
|Required Minimum Distributions (RMDs)||Begin at age 70 1/2 (though this could be moved back to age 72 if pending legislation is adopted)||No RMDs for account owner but beneficiaries would be required to take RMDs|
Source: Hartford Funds
There are a few other attributes that make a Roth IRA an interesting option for those who meet the income requirements:
- After you’ve held your Roth IRA for five years, you can withdraw your contributions without paying a penalty. You would, however, pay a penalty if you withdraw the earnings on those contributions.
- You don’t need to take required minimum distributions (RMDs) from a Roth IRA if you’re the account owner, but your beneficiaries would need to take RMDs if they inherit the account from you.
- You can withdraw money prior to age 59½ for the same reasons listed above for a traditional IRA (e.g., first-time home purchase, rule 72(t), and college/vocational school costs).
A “Backdoor Roth” Allows High Earners to Qualify for a Roth IRA
If your income level exceeds the allowable amount to qualify for a Roth IRA, you can use the back door Roth strategy if a Roth IRA is appropriate for you. You would make a nondeductible contribution for the maximum allowable amount into a traditional IRA ($6,000 if you’re younger than 50, $7,000 if you’re 50 or older). Then you would convert your traditional IRA into a Roth IRA.
This is generally a taxable event in which you pay ordinary income tax on the amount you convert into the Roth IRA, but all earnings and growth in the Roth IRA after the conversion will be tax-free after they’ve been in the account for five years. In addition, Roth IRA owners aren’t subject to required minimum distributions (RMDs), but their beneficiaries who inherit the Roth IRA will be required to take RMDs.
High income earners who have traditional IRAs, SEP IRAs, and/or SIMPLE IRAs from a previous employer can also convert these accounts to Roth IRAs. You’ll want to discuss this with your tax professional to see if you want to spread the conversion out over multiple years to avoid a large tax liability in a single year, especially if the conversion could bump you into a higher tax bracket.
Should I Invest in an IRA or 401(k)?
If your company offers a 401(k) with a company match, in most cases it makes sense to contribute enough money to take advantage of that match. For example, if your company matches contributions $.50 on the dollar up to 6% of contributions, you should consider contributing at least 6% through your 401(k) to get the full company match.
Once you contribute enough money to qualify for the company match, you should talk to your financial advisor and tax professional to determine whether it makes sense to maximize your contributions to a 401(k) vs. an IRA. Some things to consider include:
- What are the underlying expenses for the investment options in the 401(k) vs. an IRA?
- Does the 401(k) offer a good selection of investment options, or are those options fairly limited?
- Should you use an IRA to gain access to investments or asset classes that aren’t part of your 401(k)?
- If your income is high, should you contribute a portion of your money to a Roth 401(k) if your plan offers this feature?
- If your income is high, should you make after-tax contributions to your 401(k) so you can ultimately convert those contributions into a Roth IRA (i.e., a mega backdoor Roth conversion)?
To Learn More About Saving for Retirement With an IRA,
Please Talk to Your Financial Advisor and Tax Professional
1 Source: EBRI 2019 Retirement Confidence Survey
Important Risks: Investing involves risk, including the possible loss of principal.
This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not takeinto account the specific investment objectives, tax, and financial condition of any specific person.
This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot beguaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This materialmay not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express writtenconsent of Hartford Funds.