I’ve seen it constantly. I am reviewing the retirement portfolio of a client who is nearing retirement, we lay out the various accounts they have, and it’s at that point where they discover that ALL their retirement accounts are going to be taxed on ALL distributions. This realization is never met with gladness. The statement that I will inevitably hear is, “I wish I had known this before!”
By reading this page, you won’t be one of the ones who end up in that situation. At least, not if you take action from what you learn here. You will understand the key differences between the two major types of IRAs, as well as your 401(k) at your job(since the tax rules are very similar). I will not be reviewing contribution limits on this page. I am only talking about the major differences in relation to how they are taxed.
The IRS allows 3 types of tax advantages in retirement accounts. These include IRAs, 401(k)s, 403(b)s, 457s, etc. The IRS lets you take utilize 2 out of 3, but not all 3. There is no circumstance(as of this writing) that allows for all 3. The Traditional IRA and Roth IRA both utilize 1 of the 3, tax deferred growth, but differ in the 2nd perk. Let’s look at how all 3 of these work:
The first is tax deductible contributions. This means that if you put $100 into your IRA, that $100 is deductible on your current taxes and excluded from your income. It’s the same idea as contributing to a 401(k) at work and having your taxable income reduced. The difference with the IRA is that you get the money first and deduct it later. With a 401(k), you never see the money since it’s deducted before you ever get paid.
The second tax advantage is tax deferred growth. This simply means that you aren’t taxed on your growth within the account. For example, if your account value is $10,000 on Jan 1 and grows to $20,000 by Dec 31, you aren’t taxed on the growth. The great thing about this is if you have a fantastic year and double your money, you don’t lose account value to taxes and you aren’t placed into a higher tax bracket just because of your IRA. This allows for greater growth since Uncle Sam isn’t taking from it every year.
The third advantage is tax-free distributions. This refers to when a person withdraws money from the IRA. If you withdraw $1000, do you net $1000 or do you get what’s leftover after taxes? If you are taxed on the distribution, the tax rate is the same as your income. You can also potentially jump into a higher tax bracket depending on how much you withdraw from your IRA. This one has been the biggest eye-opener for clients in my career in finance.
This table illustrates which 2 of the 3 your particular IRA uses:
TDC- Tax deductible contributions
TDG- Tax deferred growth
TFD- Tax free distributions
TDC TDG TFD
Traditional IRA x x
Roth IRA x x
As you can see, you can deduct your contributions to your Traditional IRA(assuming you are within income limits) but you are taxed when you take the money out later. For the Roth IRA, you contribute with after-tax dollars, but you can withdraw the money tax-free in retirement.
It’s important to pay attention to the additional IRS guidelines concerning employment and income. These guidelines spell out who can contribute to these IRAs and who cannot. Those can be found here: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
In 2023, the contribution limit for IRAs is $6,500 if you are under 50. It’s $7,500 if you are 50 or older.
Here’s a common question I get: Can I contribute this full amount into both types of IRAs? The answer is NO. Your total IRA contribution for the year cannot exceed that number. However, you CAN spread it out between the two IRAs. This means that if you want to contribute $3,000 into a Traditional IRA and $3,000 into a Roth IRA, this is OK. What you CANNOT do is contribute $6,500 into one and $6,500 into another. You are penalized heavily for doing this if you try.
The IRS raises the limit frequently(usually annually), so it’s important to check on their website to see how much the limit is depending on what year you’re looking at doing this.
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“You may learn something, and whether what you see be Roth or Traditional, that may be profitable, and yet it may not. Seeing is both good and perilous.”