Regardless of your age, planning for retirement is a crucial part of life, especially if you’re older since you inevitably have less time to save. For those of who you are younger, try to avoid leaving it for later simply because you have “time to save.” Remember, the younger you are, the less you need to save since you have more time on your hands to reach your retirement goal.
Anyway, let’s move on to talk about the definitions of both a Roth IRA and a Tradition IRA and their differences.
Some of you may already be invested in an employer-sponsored retirement plan, but you may be looking to maximize your retirement income with something else.
An individual retirement account (IRA) is a tax-advantaged vehicle that is designed for long-term savings and investments. There are different kinds of IRAs, and they all have similarities and differences.
In this article, we will be going over the two most commonly used IRAs to find out which is most beneficial for you:
Roth IRA vs Traditional IRA.
Fair warning: this stuff might get very complicated, but I added a section at the bottom of the page that illustrates what I will explain in the following sections so that all the information is easier to understand.
MAGI and AGI
What do these terms stand for?
- MAGI – Modified adjusted gross income
- AGI – Adjusted gross income
Why do we need to know MAGI and AGI?
- Because MAGI is what we use for all of the upcoming calculations and rules, and MAGI cannot happen without AGI.
To know MAGI, you first must know AGI. So, what is AGI? AGI is defined by the following formula:
AGI = Gross Income – Deductions
(Deductions: amounts you can take away from your gross income and can cause you to pay fewer taxes)
In the majority of cases, AGI and MAGI are the same, but sometimes they’re different. When they are different, to find out what your MAGI is, you need the following equation:
MAGI = AGI + Some of the Deductions you made when you calculated AGI from your gross income
These are the deductions that you need to add back to your AGI to get your MAGI if you deducted these when calculating AGI:
- The exclusions for income from U.S. Savings bonds
- Student Loan Interest
- Qualified tuition expenses
- One-half of self-employment tax
- Tuition and fees deduction
- IRA contributions, taxable social security payments
- Passive loss or passive income
- The exclusion under 137 for adoptions expenses
- Any overall loss from a publicly traded partnership
- Rental losses
Everything is based on MAGI when it comes to your IRAs, not just regular gross income.
Roth IRAs and Traditional IRAs – How Are They Similar?
To get a good idea of what these two accounts are, it’ll make things a lot easier to understand if we go over the similarities of Roth IRAs and Traditional IRAs first.
Roth IRAs and Traditional IRAs have many similarities, aside from being for retirement and tax-advantaged (their tax advantages are different, and we’ll go over those in the next sections), they can both be contributed to by minors and nonworking spouses. They both have the same contribution deadline for the given tax year, April 15th (July 15th for COVID-19 Pandemic issues in 2020).
Both IRAs also have the same limit of contribution.
- $6,000 limit for people less than 50 years of age
- $7,000 limit for people more than 50 years of age
If you wanted to, you could open both of these accounts, but one thing to keep in mind is that, in total, you cannot contribute more than the limited amount for that given year. For example, if I am under the age of 50, meet the requirements to contribute to both, and want to contribute equally to both, I cannot contribute $6,000 to each. I can; however, contribute $3,000 to each one to meet my total limit of $6,000.
As you can, their similarities are minimal even though they are both IRAs. Now, let’s look at their difference.
I’ve actually made an entire article that goes over Roth IRAs, their intricacies, and why they’re a good idea to have; I recommend checking out the article!
A Roth IRA is an account that simply acts as a shield against taxes. It is nothing more than a safe place where you can make any type of investment you want within it. You could even just use it to save your money if you didn’t want to invest (although, I wouldn’t just save my money in one).
The biggest thing about a Roth IRA is that the contributions are not tax-deductible. This means that you don’t get current tax benefits from the contributions you’ve made. This is because a Roth IRA’s contribution can only be done with after-tax income. On the positive side, Roth IRAs can grow completely tax-free.
What does that mean? It means that when you are ready to retire, you can withdraw your funds from the Roth IRA completely tax-free. Any profits your money made within the account are completely tax-free. Having an account like this can be especially useful for someone who expects to be in a higher income tax bracket during retirement.
But when can you make these withdrawals completely tax and penalty-free? When you are over the age of 59.5…. yes, point five. If you make withdrawals from your Roth IRA before 59.5, you can only withdraw what you originally contribute to your Roth IRA tax and penalty-free, but you cannot withdraw the gain tax and penalty-free.
Sound confusing? Let me explain.
If you contribute $4,000 to your Roth IRA and your investments within the Roth IRA grow your money to $8,000. You now have made a profit of $4,000 from your $4,000 investment. However, you can only withdraw $4,000 (the original amount) from your account tax and penalty-free before the age of 59.5. If you withdraw anything more than the $4,000 you contributed, you will be penalized for it.
However, you might be able to avoid the 10% penalty and the taxes on withdrawals from earnings you’ve made in a Roth (aka the profit). If you’re below the age of 59.5, have had the Roth IRA for at least five years, and at least one of the following apply to you, you can avoid the 10% penalty and taxes:
- Die and the money is withdrawn by your beneficiary or estate
- Use the money (up to a $10,000-lifetime max) for a first-time home purchase
- Have a permanent disability or hardship
If you’ve only had the account for less than 5 years, you can avoid only the 10% penalty if:
- You’re at least 59.5 years old
- You use the money (up to a $10,000-lifetime max) for a first-time home purchase, qualified education expenses, or certain medical costs
- The withdrawal is due to a disability or certain financial hardships
- You die and the money is withdrawn by your beneficiary or estate
Another quality of Roth IRAs is that there is no age limit in terms of how much time you have to contribute to them and at what age you have to make distributions (aka withdrawals from the account). This means that if you lived to be 110 years old and you still didn’t want any distributions from your Roth IRA, but instead you want to keep putting money in, you can. No one can stop you.
Something else to point out about Roth IRAs is that to contribute, you must be below a certain MAGI level.
- For someone filing single, head of household, or married filing separately (and you didn’t live with your spouse at any time during the year) you can contribute the full amount limited to you for the year if you made $124,000 or less for the year. These amounts are $6,000 for age<50 and $7,000 for age>50.
- For someone filing single, head of household, or married filing separately (and you didn’t live with your spouse at any time during the year) you can contribute a reduced amount (AKA phased out amount) if you make between $124,000 and $138,999. Anyone making $139,000 or more cannot contribute.
- If married, filing jointly they can each contribute the full amount limited to their Roth IRA of $6,000 for age<50 and $7,000 for age>50. This means that the total will be $12,000 or $14,000 in total for a married couple. This is at the MAGI level of $196,000 or less.
- If married, filing jointly they can each contribute a reduced amount (AKA phased out amount) to their Roth IRA if their MAGI level is between $196,000 and $205,999. Any couple with $206,000 or more cannot contribute
If you’re wondering what the reduced amount would be if you’re in the “in-between” area with your MAGI, here are some formulas:
MAGI – $124,000 = $ / 15,000 = n x 6,000 (7,000 if age 50+) = TOTAL → $6,000 ($7,000 if age 50+) – TOTAL = Amount You Can Contribute
MAGI – $196,000 = $ / 10,000 = n x 6,000 (7,000 if age 50+) = TOTAL → $6,000 ($7,000 if age 50+) – TOTAL = Amount You Can Contribute
Yeah, the law on all this makes things a little tougher than they need to be but, hey, that’s as simple as it can be put!
For those of you wondering what the case would be if a married couple has one spouse over 50 and one spouse under 50, the spouse who is over 50 can contribute $7,000 and the spouse under 50 can only contribute $6,000. Making a $13,000 total contribution.
Just like a Roth IRA, a Traditional IRA is simply an account in which you can make any type of investment or saving. However, the tax advantages are different for a traditional IRA when compared to a Roth.
A Traditional IRA is an independent retirement account that is funded with pretax income. Traditional IRAs are tax-deductible. This means that some or all of what’s contributed to the account can be subtracted from your income for tax purposes so that you don’t pay as much in taxes that year.
On Traditional IRAs there are no reduced amounts of what you can contribute. You can contribute your full limited amount regardless of your income level. However, depending on your MAGI, there are reduced amounts that you can deduct from your income to pay less in taxes.
Tax deductions have rules which will allow you to either make a full deduction, a partial deduction, or no deduction at all. The following are the rules:
- Married Filing Jointly (you’re covered by a retirement plan at work): total MAGI between $104,000 to $124,000 can have a partial deduction
- Married Filing Jointly (you’re covered by a retirement plan at work): total MAGI above $124,000 can have no deduction
- Married Filing Jointly (your spouse is covered by a plan at work): total MAGI between $196,000 to $206,000 can have a partial deduction
- Married Filing Jointly (your spouse is covered by a plan at work): total MAGI is above $206,000 can have no deduction
- Single Head of Household (you’re covered by a plan at work): MAGI between $65,000 to $75,000 can have a partial deduction
- Single Head of Household (you’re covered by a plan at work): MAGI is above $75,000 can have no deduction
- Married Filing Separately (either spouse is covered by a plan at work): Less than $10,000 can have a partial deduction
- Married Filing Separately (either spouse is covered by a plan at work): $10,000 or more can have no deduction
Anyone who makes below the minimum MAGI levels can deduct their full contributions from their taxes! Except for the last two rules listed above. If you’re married filing separately, you don’t get very much leeway. It’ll probably be more beneficial to file jointly if you want to be able to get the best deductions possible for your contributions!
The downside about being able to make deductions for tax purposes is that the growth within the IRA does not grow tax-free. This means that whatever your investments or savings made within the IRA are taxed whenever you make distributions (withdrawals) from the account. This IRA is usually better if you’re sure that you will be in the same or a lower tax bracket when you’re ready for retirement or if you are confident that the growth within the account won’t be large.
When it comes to these IRAs, any money that you take out of the account, whether it’s your contributions or the growth that your contributions have made, is taxed and penalized at 10% if you withdraw funds before the age of 59.5.
However, there are exceptions. You can avoid the 10% penalty (but not the taxes) if it’s due to any of the following:
- If it’s for substantially equal periodic payments under the IRS’ guidelines
- Health insurance premium as long as you’ve already received 12 consecutive weeks of unemployment compensation
- Your disability or death
- If it’s for a first-time home purchase up to a max of $10,000
- If they’re being distributed to a reservist was called to active duty for more than 179 days
- If it’s for post-secondary education expenses
- Certain unreimbursed medical expenses
- An IRS levy
These are all very specific situations that common people don’t usually have to worry about, but you should look into them if you see something that does apply to you. If one does, you should consult a specialist to properly avoid the penalty.
Another particularity about Traditional IRAs is that they have something called required minimum distributions (RDM). These are mandatory (taxable) withdrawals based on a percentage from your account. These RDMs start at age 70.5 for every individual. Before that age, you don’t have to make any kind of withdrawal from your IRA if you choose not to.
The specific RDM amount varies depending on your individual life expectancy. So, for this, you need to consult with a financial professional or go to the IRS link that’s linked to “required minimum distributions” above.
These options are all relevant to those who are inheriting an IRA from someone who has passed away.
This applies to either IRA, Roth, or Traditional. There are three different ways to inherit an IRA if you’re the account owner surviving spouse.
- Assumed IRA: you get the IRA funds as long as you’re the only beneficiary on the account. The IRS will simply assume that the IRA received was yours all along. This means that you can add your own contributions to it. You don’t have to make any minimum distributions until you reach 70.5 if it’s a Traditional IRA, even if the previous owner was over 70.5.
- “Inherited” IRA: you’re going to transfer the amount in the IRA received from a previous owner into an IRA that’s already in your name. In this case, you have to take minimum distributions the year after your spouse’s death. If you aren’t the spouse then you must take minimum distributions immediately instead of the year following the death.
- Disclaim the IRA: you simply refuse to accept part or the full amount of the IRA. Put deep thought into this because once you decline it, there’s no going back!
Illustration of Everything Explained Above
As I said, I have listed some illustrations of what I explained above since I know it can get pretty confusing.
If there are any questions what so ever, please feel more than welcome to ask and I will answer them. I know this stuff can be confusing so please don’t hesitate to ask!