Individual retirement accounts come in two flavors: Roth and traditional. They are mirror images of one another when it comes to taxes.
Both a traditional IRA and a Roth allow money to grow tax-free. While inside the accounts, there is no taxation on dividends, interest or gains on the holdings. The contribution limits in 2023 are $6,500, with an additional $1,000 for those over the age of 50 ($7,500 total).
The maximum contribution is combined for both IRA accounts, so between the two, you cannot put in more than the max amount for the year. For 2022, you have until April 18, 2023 to make a contribution and the maximum amount permitted is $6,000 ($7,000 if you are over 50). You need to review your modified adjusted gross income (MAGI) for the year in which you are making a contribution to be sure you are eligible. When contributing to a traditional IRA, whether you are eligible for an employer plan (e.g. 401(k)) also determines your ability to deduct IRA contributions from your taxes.
Typically, contributions for a traditional IRA go into the account before tax. This means you get to avoid tax in the year you make the contribution. When an investor goes to pull from an IRA in retirement, the money is fully taxable as income. Therefore, the tax benefit for a traditional is in the beginning.
With a Roth, the contributions go in after-tax, and distributions are tax-free. The Roth owner does not get a tax benefit in the year the contributions go into the account. Therefore, the tax benefit for a Roth IRA comes during retirement.
Traditional and Roth IRA accounts are created to provide tax advantages. The investments inside of the accounts can vary from individual stocks, ETFs and mutual funds to certificates of deposits. Simply put, retirement accounts are a way to shelter investments from tax but the returns are determined by the assets inside the accounts.
All things being equal, a Roth provides tax shelter for all the growth inside the account, so more growth-oriented investments make sense. Younger savers will also benefit more from a Roth since, theoretically, they are making their lowest salary (low taxes), they can be more aggressive investing and have longer to let the money grow tax-free.
A traditional IRA can provide a tax deduction for the year you make the contribution. It is useful in your high earning years when taxes may be the highest.
Roth and traditional IRAs were created to save for retirement. Therefore, investors are restricted from taking money before they are 59 ½ or face tax penalties; however, there are exceptions. The IRS has permitted higher education expenses, first-time home buyer and birth or adoption exceptions to the 10% early withdrawal penalty. The Roth is even more generous because contributions are already taxed, so the IRS permits contributions to be withdrawn without the penalty.
Traditional IRA accounts require that distributions must be made based on age and the account value each year after the owner reaches age 73 (this was just increased this year in the SECURE Act 2.0). A Roth, given it is not taxable, does not have a required minimum distribution requirement and money may be kept inside the account.
Beneficiaries of traditional IRA and Roth IRA accounts typically must take money from the accounts within 10 years of inheritance. There are many variables and exceptions to this rule, one being a spousal beneficiary. It is important as an owner of an individual retirement account to be aware of this when naming beneficiaries. It is important to have named beneficiaries on the accounts and to review these periodically.
Traditional and Roth IRA accounts can be advantageous when a worker has no employer retirement or is not eligible yet. It can also supplement what is going into an employer plan. There are many complicated exceptions, rules and regulations on individual retirement accounts, their contributions and distributions. When in doubt, speak to an expert on what individual account works best for your situation and why.
Judy Loy is a Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc. in State College.
All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice. Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.
