Properly saving for retirement requires answering many questions. How much money do you need to save to securely retire? What products are available to accumulate enough savings? How is a 401(k) different from an individual retirement account?
What makes many of these questions tricky is the fact that the right answers depend on an individual’s unique financial circumstances. What’s true for everyone, however, is that understanding the differences between long-term retirement savings tools is key to making investment decisions that will help you achieve your savings goals and position you for financial success in retirement.
The role of IRAs in saving for retirement
To be sure, there are numerous retirement savings tools to choose from. A 401(k), for instance, is an employer-sponsored retirement savings account. Taking advantage of a 401(k)—especially if your employer matches a percentage of your contributions—can be one pillar in your retirement savings strategy.
Another key pillar in saving for retirement is individual retirement accounts (IRAs). The two most popular types of IRA are traditional and Roth. Both types of IRAs give investors access to a wide variety of investment options that have the potential to grow over time and eventually provide income to retirees. The range of investment options can suit differing risk appetites and investment preferences—everything from certificates of deposit (CDs) to funds that invest in large, medium or small companies to those that focus on a particular industry or country.
But before making any choices about which specific IRA fund is best for you, it’s essential to understand the unique rules, features and tax advantages of both traditional IRAs and Roth IRAs.
Traditional IRAs
For investors who save for many years, or even decades, traditional IRAs have the potential to accumulate significant earnings. One big reason is that IRAs allow you to take advantage of tax-deferred compound growth.
At the most basic level, compound growth is when both the assets in an IRA as well as the interest they earn are continuously reinvested over time. For example, if you have $10,000 in an IRA and it earns a 5% return in a year, your IRA will be worth $10,500 because it added $500 in interest. If the IRA earns a 5% return the next year, the interest will be $525, and the value of the IRA will reach $11,025.
While traditional IRAs are a long-term investment vehicle, they also can provide immediate tax benefits. That’s because contributions to traditional IRAs are tax-deferred, which means that you only pay taxes when you withdraw IRA funds in retirement. Contributions to traditional IRAs also have the immediate benefit of being tax deductible. Put simply, if you contributed $6,500 (the maximum deductible amount for those under age 50) in 2023, that means the taxable income on your 2023 return was reduced by $6,500. Traditional IRA contribution limits rise to $7,000 for people under age 50 in 2024 and $8,000 for those 50 and over.
Caveats to IRA tax deductions
If you or your spouse have a 401(k) account at work, your income determines what percent of your IRA contributions are tax deductible. For example, if you file taxes as either single or head of a household and made $77,000 or less in 2024, you can deduct your entire IRA contribution even when you have a 401(k). If you make between $77,000 and $87,000, you can make a partial deduction. But if you earn more than $87,000, no deductions are allowed.
Traditional IRAs also have required minimum distributions (RMDs), which obligate IRA owners to withdraw a certain amount each year, starting at age 73. The RMD is calculated by dividing the amount of money in an IRA by a life expectancy factor provided by the Internal Revenue Service (IRS). Also, keep in mind that withdrawing money from an IRA before age 59 1/2 counts as part of your taxable income while triggering a 10% tax penalty.
When you start to make withdrawals from a traditional IRA to fund your retirement, that is when taxes are due. This is an important point in determining whether a traditional IRA is right for you. The fact that you will have to pay taxes on IRA distributions in retirement means that you’ll want to be in a lower—or at least the same—tax bracket as when you originally invested in the IRA.
Roth IRAs
Roth IRAs share many of the attractive features that make traditional IRAs a good vehicle to save for retirement. Like traditional IRAs, Roth IRAs allow investors to choose from a wide variety of investment funds and also benefit from compound growth.
But Roth IRAs are meaningfully different from traditional IRAs, and those differences can make them a better or worse choice depending on a retirement saver’s circumstances. The main difference with Roth IRAs is that contributions are not tax deductible. In other words, your taxable income will not be lower in the tax year you make contributions to a Roth IRA.
Roth IRA tax benefits kick in when you withdraw money during retirement because those withdrawals do not count as income. That difference makes Roth IRAs a potentially better choice for people who anticipate that they will be in a higher tax bracket during retirement, when tax-free income streams can improve their overall financial picture.
Another significant difference between traditional and Roth IRAs is that Roth IRAs do not have required minimum distributions (RMDs) while the owner of the account is still alive. Like traditional IRAs, Roth IRAs also have maximum contribution limits that are based on an investor’s income. For the 2024 tax year, single and head-of-household tax filers can contribute $7,000 ($8,000 for those aged 50 and up) if their modified adjusted gross income is below $146,000. Those who are married and filing taxes jointly can contribute the maximum allowable amount to a Roth IRA in 2024 if their adjusted gross income is below $230,000. Withdrawing funds from a Roth IRA before age 59 1/2 triggers an additional 10% tax penalty, unless an exception applies.
The Backdoor Roth
There is one wrinkle to the income restrictions on Roth IRA contributions. Known as a “backdoor” Roth IRA, this is when those with incomes that are too high to qualify to contribute instead put money they already paid taxes on into a traditional IRA. That traditional IRA can then be legally converted into a Roth IRA, which allows those with high incomes to still take advantage of the unique tax benefits of a Roth IRA in retirement.
Need help with your financial future? Saving for retirement is a long journey, but Byline is here to help with IRAs to suit your financial circumstances today and in the future. Stop by a branch and learn more.</blockquote
