The legislation that allowed the first Individual Retirement Account or IRA was passed in the early 1970s. The two primary goals of the IRA were to give a tax-advantaged retirement plan to employees of businesses that were unable to provide a pension plan. The law also established a vehicle for preserving the tax-deferred status of qualified plan assets when an employee left a company. This is known as a rollover. In the late 1990s the Roth IRA was introduced to further entice savers to contribute to a self-directed retirement account.
The success of the IRA in all forms is indisputable. As of the end of 2018, nearly 42 million American households held nearly $10 trillion in IRAs.
Both traditional and Roth IRAs can help you save for retirement. And we always advise clients and their children to open one or the other or both as soon as possible after starting to earn money from working. Over a long career, situations change and there are different rules and advantages for each about taxes on contributions and withdrawals. That is why so many people end up with several IRAs when they’re ready to retire. The best thing about any IRA is that earnings and capital gains are not taxed while in the account. This can provide a huge advantage over time while saving for retirement.
No escaping taxes
Make no mistake – whether a traditional or a Roth IRA, you pay taxes – it is just a matter of when. With a traditional IRA, if it’s one that you contribute to with pre-tax earnings or one that you rollover when you leave a company-sponsored 401k or profit-sharing plan, you are taxed when you take distributions in retirement. A Roth IRA is funded with after-tax dollars and distributions are never taxed.
A traditional IRA generally allows you to deduct your contributions from your taxable income. As an example, if you contribute $6,000 to an IRA, your taxable income is reduced by that amount. Down the road, when you withdraw money from that account, you will pay taxes based on your individual tax rate at that time. Many savers end up in a lower tax bracket when they retire, which makes a traditional IRA a good choice.
On the other hand, one reason that we recommend that young people contribute to a Roth IRA is that when someone is first starting out, their earnings are lower and so is their tax rate. A young person funding a Roth IRA with after-tax dollars never pays taxes on those funds again. If your investments grow over many years, the net-of-tax return on a Roth IRA can be significant.
Best of both worlds
Retirement planning experts recommend having a combination of post-tax and pre-tax accounts to draw upon in retirement. This might mean having both a Roth IRA and a traditional IRA. Since you do not know what your income or tax bracket will look like during any given year of your retirement, having the option to withdraw money from a Roth tax free in years when your income is higher and to withdraw taxable funds from a traditional IRA in years when your income is lower can keep your tax bill as low as possible. In any case, having more than one bucket of money to draw from gives you more control and you can decide which is more advantageous.
As you might expect, there are many rules and limitations regarding how much money you can contribute to the various types of IRAs. These depend on your income, whether you are a single or married filer and whether you participate in an employer-sponsored plan at work. You can only contribute to an IRA with earned income – investment income from interest, dividends, Social Security benefits and child support are not considered earned income by the IRS. Regardless of your age or earnings status, it’s important to be aware of the choices available to you. As usual, we’re happy to answer any questions that you may have.