By Eric Ellis | February 5, 2021 | Roth IRA & Traditional IRA
A common question we hear is “What is the difference between a Roth IRA and a traditional IRA?” It really boils down to the tax treatment.
When you add money to a traditional IRA it is money you have not paid taxes on yet. Keyword: Yet. You know Uncle Sam is going to get his “fair share”. The assets you accumulate in your traditional IRA will eventually be taxed, with one exception. However, while they are in your traditional IRA they are not. They grow and stay tax-deferred (taxes are postponed) until you withdraw the assets from your account. Then only the amount you withdraw is taxed. For example, If you have $2,000,000 in your traditional IRA but only withdraw $25,000. You will only pay taxes on the $25,000 withdrawn in the year you withdraw it.
- Saves you money in taxes.
- Contributions to your traditional IRA will reduce your taxable income in the year you contribute.
- You do not pay taxes on any changes to your investments within your traditional IRA. Assets grow tax-deferred.
- Withdraws from your IRA are taxed as ordinary income.
- If you withdraw assets from your IRA before 59 1/2, a 10% penalty is in addition to the ordinary income tax.
- At age 72, the IRS requires you to withdraw a portion of your IRA. This is called your Required Minimum Distribution (RMD).
- Saves you money in taxes.
You can add $6,000 in 2021 to your IRA (an additional $1,000 if you are older than 50. However, if you are contributing to an employer-based retirement plan, 401(k), SEP-IRA, SIMPLE IRA, 401(b), 457… etc., there are more items to be conscious of. If you earn more than $65,000 as a single filer or $104,000 married filing jointly (Adjusted Gross Income) your contribution amount will be reduced. If you are single and earn more than $75,000 or married filing jointly and earn more than $124,000 you cannot make a deductible contribution that year. Meaning you can add to your IRA but you will not be able to reduce your taxable income by the contribution amount.
Your contributions to a Roth IRA is with money you have already paid taxes on. Since you have paid taxes on these assets, as long as you play by the rules you will never pay taxes on the money in this account again. This can be a huge advantage and the more time one has on their side the benefits are exponential. Once the assets leave the Roth IRA, those assets are no longer tax-free and taxes will be assessed.
- Contributions do not lower your taxable income.
- Assets grow tax-deferred and withdrawals are tax-free. In other words, you pay no taxes since you have already paid them before contributing to your Roth IRA.
- If you withdraw assets from your Roth before 59 1/2 and the resources have not been in your Roth IRA for 5 years, you will have a 10% penalty from the IRS in addition to the ordinary income tax.
- No Required Minimum Distributions
You can add $6,000 in 2021 to your Roth (an additional $1,000 if you are older than 50. If you earn more than $124,000 as a single tax filer or $196,000 married filing jointly you can make a reduced contribution. However, if you earn more than $139,000 as a single tax filer or $206,000 married filing jointly you cannot contribute to your Roth that year. Full reference.
Wait There is More
There are a lot of unique details about IRAs. We strongly encourage you to discuss this with your financial professional so they can share any relevant information that is unique to your circumstances. Below are a few more items we thought were worth mentioning.
In 2021 $6,000 is the total amount ($7,000 if you are 50 0r older) you can contribute to all IRAs (Roth and Traditional). This means you cannot add $6,000 to a Roth IRA or $6,000 to a traditional IRA but not both. You could split the $6,000 between the two IRAs, however, you like. $3,000 Roth and $3,000 Traditional. $5,000 Roth and $1,000 Traditional. As long as your total contributions are not more than $6,000.
Types of Income
Not all income qualifies to be able to contribute to these retirement accounts. Rental income, pension income, investment income do not qualify. Wages, salaries, commissions, tips, bonuses, or net income from self-employment do qualify.
You are one-of-a-kind. Your financial planning should be too. Discuss these topics with your financial professionals so they can give you professional advice on what is best for your personal situation.
Ellis & Company Retirement Strategists