Retirement Planning Basics: Traditional & Roth IRAs

They say it’s never too early to start planning for retirement, but the retirement resources out there seem to assume that people already have an encyclopedic knowledge of retirement planning jargon. Well, you know what they say about assuming things… so here at NEST, we try to avoid it. 

Last time we discussed 401(k)s, and in this segment of our beginner’s guide to retirement planning we’re discussing the IRA, or individual retirement account. An IRA is similar to a 401(k) in that it is a tax-advantaged account whose funds are intended for – you guessed it – retirement. 

Like a 401(k), an IRA is composed of stocks, bonds, and other assets, and how much your account accumulates depends on these investment vehicles and how much money you contribute to the account. Either contributions or withdrawals are tax-free, depending on the type of IRA.

However, there are distinct differences between the two types of accounts, and it’s important to understand them so that you can make the best choice for your financial goals and future. 

Traditional and Roth IRAs are not associated with your employer, which means they are not eligible for employer matching. They also have much more restrictive contribution limits. 

On the other hand, IRAs open up your investment options significantly compared to a 401(k). Rather than being limited by your workplace’s options, IRAs give you more freedom when it comes to how you invest, and also permit more flexibility when it’s time to withdraw your funds. 

Let’s dive into the details. 

The Basics

Instead of being affiliated with your workplace, traditional and Roth IRAs are opened at banks or brokerages. In the context of IRAs these financial institutions are often called “custodians”, since they take custody of your money. 

Since it’s not designed by your employer, an IRA empowers you to design your own portfolio. You get to choose the investment vehicles you want your account to be composed of, from stocks and bonds to mutual funds or ETFs. Another option is to buy a target-date or life-cycle fund, which is a mix of stocks and bonds that are designed to automatically adjust over time as your risk tolerance goes down the closer you get to retirement age. 

While IRAs allow for more diversity in investments than 401(k)s, the contribution maximums for IRAs are much lower for an IRA compared to a 401(k). 

For 2021 and 2022, the maximum contributions that a person can make annually to all of their IRAs can’t be more than $6000 for people aged 49 and younger, or $7000 for people aged 50 and above.  Since the traditional and Roth IRAs are not affiliated with your workplace, the option of employer matching is also not available for these retirement accounts. 

Depending on your risk tolerance and goals, it’s a good idea to contribute as much as you can up to the maximum permitted into your IRA. If you’re not going to need your money in the immediate future, these kinds of accounts are a wiser option than letting your money sit in a savings account where it will lose spending power due to inflation. 

Make sure to have an understanding of the different withdrawal requirements, contribution limits, and fees associated with the choices you make in regard to your IRAs. In addition to the IRS’ limits on contributions, there are limits to tax deductions based on individual or joint income to consider as well. 

Traditional IRAs

Contributions to traditional IRAs are tax-deductible, reducing your taxable income by the amount that you contribute to the account. In retirement, the withdrawals that you make from your IRA will be taxed as ordinary income. 

You must have earned income to open a traditional IRA, and your annual contributions can not exceed what you earned that year. Other than that and the IRS-imposed contribution limits, the only restrictions on these accounts relate to tax deductions. 

The percentage of your contributions that you can deduct for tax advantages varies based on your income and other retirement accounts. In 2021, if you are single you can claim full deduction from your contributions if you earned $66,000. If you earn more than $66,000 but less than $76,000 you can claim partial deduction in 2021, and you can claim no deduction in 2021 if you earn more than $76,000. These numbers are adjusted for inflation in 2022. There are different stipulations for married couples who file jointly, married couples who have retirement plans at work, and married couples who file separately.

If any of these details apply to your situation, you can still contribute to an IRA, your contributions just may not be 100% tax deductible.  

Roth IRAs

Roth IRAs, on the other hand, play by an entirely different set of rules. If you recognize the word “Roth” from the 401(k) exposee, you’re right: the Roth IRA is similarly tax-advantaged. Contributions to the Roth IRA are not tax-deductible while withdrawals are tax-free, so there are no taxes on the gains that are accumulated. This is a good option for people who have a long time for their accounts to grow before they plan to retire, which avoids taxing a larger sum of money and hedges against potential tax increases far in the future.

In 2021, individuals can contribute to a Roth IRA as long as they earn less than $125,000. Contributions are reduced for individuals earning $140,000 and eliminated for individuals earning more than that figure. For couples in 2021, the contribution is reduced at $198,000 joint income and eliminated at $208,000. 

Withdrawals

Withdrawing the money from an IRA is typically prohibited to a certain age, as with a 401(k) account. You may face a 10% penalty and tax bill if you withdraw money from a traditional or Roth IRA before age 59.5. Roth and traditional IRAs have notable exceptions to this rule, however. 

You can distribute a portion of your money from your traditional IRA before age 59.5 and avoid the penalty if you are using the funds to purchase your first home (capped at $10,000), cover disability costs and certain medical expenses, and pay for qualifying higher education or child care expenses, among other reasons. 

One interesting nuance of the Roth IRA is that you are never required to withdraw money – you may let it stay in the account for your beneficiaries. This is unique to this type of account, as most retirement accounts including traditional IRAs require withdrawals around age 70. 

A financial advisor can help you understand when it’s appropriate to withdraw your traditional IRA funds and avoid penalties. 

Either / Or / And

IRAs offer another way to save for retirement and get some tax reduction perks while you’re at it. The traditional and Roth IRAs generally offer more freedom and personal choice when it comes to how your future retirement dollars are invested, which can be a benefit for some and a drawback for others – it really comes down to personal preference. 

The contribution limits are much lower for traditional and Roth IRAs compared to 401(k) plans, but withdrawal is generally a little easier for IRAs.  You can have either or both IRAs and 401(k) accounts, but this may affect how much of your IRA contributions are tax deductible. 

Creating an optimal retirement planning strategy depends on a number of factors and your personal goals. Retirement planning can feel overwhelming, but the investment in your future is worth it. If you’d like to connect with our financial planning professionals and create a comprehensive financial plan that’s best for you now and in the future, email us at info@nestfinancial.net and join the other Austin families and individuals who are taking control of their future. 

Find us on:

LinkedIn  Facebook  Yelp  Twitter

DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net