Have you thought about how much you’ve saved for retirement or how you’re saving for retirement? Many Americans think that they need at least $1 million in savings to be able to retire comfortably, but the reality is that most have nowhere near that amount saved up.
One thing that can prevent people from saving for retirement is not having access to a retirement account through their job. That’s where an IRA, or individual retirement account, can come in handy.
An IRA is an account that lets you put money aside for retirement. You can open an IRA whether or not your employer offers a company-sponsored plan.
If you have no other retirement savings options available to you or you want to contribute to an additional savings vehicle outside of your company-sponsored plan, an IRA can be ideal for jumpstarting your savings. However, there are a few things to know about the accounts before you get started.
A Brief History of IRAs
The IRA started in 1974 as part of the Employee Retirement Income Security Act (ERISA). One of the things that spurred Congress to pass ERISA was the closure of Studebaker-Packard Corporations, a manufacturing company, that left its former employees without a pension or any real retirement savings. (From the start, IRA has been the acronym for Individual Retirement Arrangement, although it is now commonly accepted to use the word “account” instead of “arrangement” when referring to an IRA.)
From the beginning, there was a limit on the amount a person could contribute to their IRA each year. Back in 1974, the amount was capped at $1,500 per year. It’s since increased and may continue to rise in the future.
Over the years, the rules for who can contribute to a Traditional IRA and how much they can contribute have evolved. One of the biggest changes to IRAs happened in 1997, with the passage of the Taxpayer Relief Act.
The Taxpayer Relief Act introduced the Roth IRA, named for William Roth, a senator from Delaware. Although the Roth IRA had some things in common with a Traditional IRA, there were also some major differences. Let’s take a look at how a Roth IRA compares to a Traditional IRA.
Roth vs. Traditional IRA
At a Glance – Roth vs. Traditional IRA
How Traditional IRAs Work
A Traditional IRA is a type of tax-deferred retirement account. That means you aren’t responsible for paying tax on the interest or earnings in the account until you begin to withdraw from it during retirement.
Not everyone is eligible to contribute to a Traditional IRA. A few things that affect your eligibility for an IRA include whether or not you have earned income and your age. If you want to open and put money into a Traditional IRA, you need to be under the age of 70 1/2.
It’s worth pointing out that there’s an exception to the earned income rule. If you’re married and file a joint tax return with your spouse, but you don’t have a paying job, you’re still able to add to your own Traditional IRA. In this case, your spouse’s income counts as your own.
In addition to allowing interest to accrue on a tax-deferred basis, there may be additional tax benefits associated with an IRA.
The IRS has several rules about when contributions to an IRA can be deducted. As of 2019, according to the IRS, you can deduct your full contribution (up to $6,000 for people under age 50 in 2019 or $7,000 for people over age 50 in 2019) if you have a retirement plan at work and your adjusted gross income is less than:
- $64,000 if single or head of household
- $103,000 if married filing jointly or a widow(er)
- $10,000 if married filing separately
As of 2019, if you have a retirement plan at work, you can’t deduct any amount of your Traditional IRA contribution if your income is over:
- $74,000 if single or head of household
- $123,000 if married filing jointly or a widow(er)
- $10,000 if married filing separately
If your income falls between those limits and you have a retirement plan at your job, you can still deduct some of what you contribute to a Traditional IRA, but there are limits to the amount that’s tax deductible.
The amount of your contribution that’s tax deductible can be affected by your spouse’s employer-sponsored retirement plan options. Even if you don’t have a retirement plan at your job but your spouse does, you might not get to deduct what you put into a Traditional IRA. In 2019, the income limits to pay attention to if your spouse has a retirement plan and you don’t are:
- Less than $193,000 and you file jointly: You can deduct your full IRA contribution.
- More than $203,000 and you file jointly: You can’t deduct your IRA contribution.
- Between $193,000 and $203,000: You can take a partial deduction.
- Less than $10,000 and you file separately: You can deduct your full IRA contribution.
- More than $10,000 and you file separately: No deduction.
Traditional IRA Distribution and Withdrawal Rules
Since Traditional IRAs are designed to be retirement accounts, allowing you to build up a nest egg for your retirement years, they have a few rules when it comes to when you can begin to withdraw money and when you are required to start taking distributions.
As a general rule, it’s recommended that you not withdraw from a Traditional IRA before you’re age 59 1/2. You aren’t forbidden from doing so, but there are some penalties imposed if you need to take money out before that age.
One of those consequences is a 10% penalty tax on the amount you take out of the account before age 59 1/2. This paired with a penalty of paying income tax on the amount you withdraw, at your current tax rate, can make withdrawing funds early a very costly decision.
Another long-term consequence is that pulling money out of your IRA before you’re age 59 1/2 or before you retire has a negative impact on the amount your total account can grow over time.
Another thing to understand about a Traditional IRA is that it has something called a required minimum distribution. Once you turn 70 1/2, you need to start taking money out of a Traditional IRA. The amount of a required minimum distribution varies based on multiple factors, such as the balance of the account. You may face additional penalties if you don’t start taking distributions after age 70 1/2.
How Roth IRAs Work
In many ways, a Roth IRA is similar to a Traditional IRA. Both have the same contribution limits ($5,500 for those under age 50 or $6,500 for people over age 50). Both are designed to help give people a tax-advantaged way to save for retirement, whether or not they have a plan from their employer.
But there are some pretty significant differences between a Roth and Traditional IRA. The first big difference has to do with taxes.
Contributions you make to a Roth IRA are made with “after-tax” dollars. This means there may be different tax advantages than with a Traditional IRA.
The trade-off is that when it’s time to withdraw from the account, you don’t have to pay income tax on the original contribution amount or any earnings in the account (such as interest). Depending on your current tax bracket and the tax bracket you expect to be in once you retire, contributing to a Roth IRA can mean considerable tax savings.
Another significant difference between Roth and Traditional IRAs has to do with when you can take money out of the account. You’re able to withdraw the original amount of your contribution from a Roth IRA at any time, for any reason, without paying income tax or a 10% penalty tax.
It’s important to note that if you withdraw any part of the interest or other earnings in the account before you reach the age of 59 1/2, you may have to pay a penalty tax.
For example, you added $2,000 to a Roth IRA, and that amount earned $200 over the course of a few years. If you withdraw the $2,000, you won’t pay any income or penalty taxes. But if you withdraw $2,200, you may have to pay tax on the $200.
There are some exceptions to the early withdrawal penalty for both Traditional and Roth IRAs. For example, if you meet certain requirements and take money out of an IRA to buy a first home, you won’t be charged a penalty for early withdrawal.
Another critical difference between Roth and Traditional IRAs is that you can leave the money in a Roth IRA for the rest of your life. There aren’t any required minimum distributions, no matter how old you are.
Another important thing to know about Roth IRAs is that, like Traditional IRAs, there are limits on who can contribute to one. If you earn more than the following (for 2019), you can’t contribute to a Roth IRA:
- $137,000 for single/head of household
- $203,000 for married filing a joint return or widow(er)
$10,000 for married filing a separate return.
Traditional IRAs vs. Roth IRAs vs. 401(k)
Now that you know the differences between Traditional and Roth IRAs, how do IRAs compare to a 401(k) plan offered by an employer?
While they all may be similar in offering possible tax benefits, there are a few important differences among all three options. One significant difference is that you can only get a 401(k) plan through an employer. You’re not able to open one on your own. You can open an IRA independently through any financial institution that offers them.
Another significant difference is the amount you can put into a 401(k) compared to what you can contribute to an IRA. For 2019, the maximum amount you can contribute to a 401(k) is $19,000. If you’re over age 50, you can put in an additional $6,000 per year (for 2019).
How you make contributions also differs between a 401(k) and a Traditional IRA. When you have a 401(k), you never actually “see” the money you put into it. Your employer withholds the funds from your paycheck and funnels them directly into your account.
With a Traditional IRA, you receive the money in your paycheck or another income source, then you can move it into your IRA.
As with a Traditional IRA, any earnings in your 401(k) are tax-deferred, so you pay tax on them when you start pulling money out during retirement. There’s also a 10% penalty tax for early withdrawals if you have to take money out before age 59 1/2.
In some cases, employers offer to match a portion of the amount an employee puts into a 401(k). If your employer does match contributions, however, either in total or up to a certain percentage of your income, it can be an excellent way to get additional money for retirement.
Who Controls a 401(k)?
When you open an IRA, whether it’s a Roth or Traditional option, you have full control over the account. You get to choose the financial institution you work with and where you put your money, such as with a savings account.
That’s not the case with a 401(k) plan. Since the plan is sponsored by your employer, your company gets to pick which financial institution manages it. In some cases, employees are limited when it comes to choosing how or where they save their money.
Since you don’t have any control over where the plan is located or who manages it, you also have little control over the cost of the plan. Management fees and other expenses might seem small, but they can significantly eat into your retirement savings.
At a Glance – Traditional IRAs vs. Roth IRAs vs. 401(k)s
|401 (k)||Traditional and Roth IRAs|
|Contribution Limit (2019)||$19,000||$6,000 (both)|
|Contribution Limit for People over Age 50 (2019)||$25,000||$7,000 (both)|
|Tax Deductible||Contributions are pre-tax||Traditional IRA: Yes, with limitations|
Roth IRA: No
|Tax on Earnings||Yes (tax-deferred)||Traditional IRA: Yes (tax-deferred)|
Roth IRA: No
|Age When You Can Make Withdrawals Without Penalty||59 1/2||59 1/2 (exceptions: you can withdraw Roth IRA contributions, but not earnings, any time)|
|Age Limit for Contributing to the Account||70 1/2||Traditional: 70 1/2|
Roth: No age limit
|Age You’re Required to Start Taking Distributions||70 1/2||Traditional IRA: 70 1/2|
Roth: No age requirement
|Penalty for Early Withdrawal of Contributions||10% tax (plus income tax)||Traditional IRA: 10% tax (plus income tax)|
Roth IRA: None
|Penalty for Early Withdrawal of Earnings||10% tax (plus income tax)||10% tax (both Traditional and Roth, plus income tax for Traditional IRA)|
|Income Limits||No limits||Yes (both)|
Other Retirement Account Options
You aren’t necessarily limited to either a 401(k) or IRA if you’re looking to save money for retirement. There are also other account options available. Consult with a trusted financial advisor to learn more.
Open an IRA Today
For many people, opening an IRA is the quickest and easiest way to start saving for retirement. If you can’t decide between a Traditional IRA or a Roth, you have the option of opening one of each. You can only add $5,500 total to your IRAs for the year, though, even if you have more than one. That means you’d need to decide how to split up your contributions between a Traditional and a Roth IRA — $4,000 to the Traditional and $1,500 to the Roth, for example.
PSECU offers both Roth and Traditional IRAs. Learn more about our IRAs and get ready to open an account today.