Individual Retirement Accounts, both Traditional IRA and Roth IRA, are a fantastic type of account for saving and investing for retirement.
These accounts were created by the U.S. Congress and to encourage Americans to save more for retirement. These accounts have the benefit of lower taxes than other types of investment accounts, such as regular brokerage accounts.
If done properly, you can use these types of accounts to build wealth faster than other types if investment accounts because your money grows tax deferred or tax free. The IRAs sets rules on how these accounts can be used. Read on to learn how to use these accounts to build your wealth.
Traditional and Roth IRAs allow you to growth your investments faster than other types of accounts because your money grows tax deferred or tax free Click To TweetIRA Comparison
Both types of IRAs have their advantages. Here’s a comparison of the benefits and differences between Traditional IRAs and Roth IRAs.
| Traditional IRA | Roth IRA | |
|---|---|---|
| Tax advantages | Tax deferred: tax deduction in current tax year and tax deferred gains until withdrawal | Tax-free gains and qualified withdrawals |
| Eligibility | Anyone with taxable income (there are income limits to qualify for the tax deduction) | Anyone with taxable income (with income limits) |
| Contribution limits (annual) | $6,000 ($7,000 for those 50 or older) | $6,000 ($7,000 for those 50 or older) |
| Taxes on withdrawals | Taxes on any withdrawals or pre-tax contributions or earnings | No taxes on contributions No taxes on earnings as long as they meet qualified withdrawal rules |
| Withdrawal rules | Early withdrawals before age 59 1/2 are subject to 10% penalty Subject to Required Minimum Distributions (RMDs) starting at age 72 (and associated taxes) | Qualified withdrawals after age 59 1/2 (or you may pay taxes and 10% penalty) Not subject to RMDs |
Eligibility
Generally speaking anyone with earned/taxable income can contribute to an IRA. If you are married and file jointly, you can still contribute if you don’t have earned income but your spouse does have earned/taxable income.
Additionally, for Roth IRAs your modified adjusted gross income (AGI) must be below certain levels to be eligible. For single tax filers your modified AGI cannot exceed $139,000. For married filing jointly couples, your modified AGI cannot exceed $206,000. Traditional IRAs do not have any restrictions based on income.
Contribution limits
In 2020 individuals can contribute up to $6,000 total across Traditional and Roth IRA accounts. If taxable income is less than $6,000, then the taxable income is the contribution limit.
Individuals 50 years or older can contribute $7,000, or up to the maximum of their taxable income.
| Year | Contribution limit |
|---|---|
| 2019 | $6,000 (or $7,000 if age 50 or older) or taxable income for the year |
| 2018 | $5,500 (or $6,500 if age 50 or older) or taxable income for the year |
Roth IRA contribution limits
Roth IRAs have contribution limits by income. Single tax filers that make less than $124,000 can contribute up to the annual maximum ($196.
| Tax filing status | Modified Adjusted Gross Income | Contribution limit |
|---|---|---|
| Single | less than $124,000 | up to $6,000 limit (or $7,000 if 50 or older) |
| $124,000 to $139,000 | reduced amount | |
| $139,000 or more | $0 | |
| Married filing jointly (or widow/er) | less than $196,000 | up to $6,000 limit (or $7,000 if 50 or older) |
| $196,000 to $206,000 | reduced amount | |
| $206,000 or more | $0 |
Traditional IRA tax deduction limits
Contributions to Traditional IRAs may be tax deductible, depending on your income. Contributions to Roth IRAs are never tax deductible. Tax deduction eligibility depends on if you (or your spouse if you file taxes jointly) are covered by a retirement plan at work and your modified adjusted gross income.
If you are covered by a retirement plan at work see the following table:
| Tax filing status | Modified Adjusted Gross Income | Deduction |
|---|---|---|
| Single | $65,000 or less | Full deduction |
| $65,000 to $75,000 | Partial deduction | |
| $75,000 or more | No deduction | |
| Married filing jointly | $104,000 or less | Full deduction |
| $104,000 to $124,000 | Partial deduction | |
| $124,000 or more | No deduction | |
| Married filing separately | $10,000 or less | Partial deduction |
| $10,000 or more | No deduction |
If you are not covered by a retirement plan at work see the following table:
| Tax filing status | Modified Adjusted Gross Income | Deduction |
|---|---|---|
| Single | Any income | Full deduction up to contribution limit |
| Married filing jointly or separately with a spouse who is not covered by work plan | Any amout | Full deduction up to contribution limit |
| Married filing jointly with a spouse who is covered by a work plan | $196,000 or less | Full deduction up to contribution limit |
| $196,000 to $206,000 | Partial deduction | |
| $206,000 or more | No deduction | |
| Married filing separately with a spouse who is covered by a work plan | $10,000 or less | Partial deduction |
| $10,000 or more | No deduction |
IRA contribution deadline
Contributions can be made anytime during the current calendar year up until the tax filing deadline for that year. For example, 2020 contributions can be made from January 1, 2020 through April 15, 2021.
Withdrawing from IRAs
Roth IRA qualified withdrawal rules
With Roth IRAs, you can withdraw your contributions without tax or penalty at any time because your contributions have already been taxed. However the IRS has outlined certain rules to withdraw earnings from Roth IRAs tax free:
- You’re at least 59 1/2 years old
- You’ve had the Roth IRA for at least 5 years
There are some exceptions. If you are younger than 59 1/2 and have had the account for at least five years you can still take a qualified distribution if you meet any of the following criteria:
- You have a permanent disability
- Withdrawal will be used to buy your first home ($10,000 lifetime limit applies)
- You inherited the IRA
Withdrawals of Roth IRA earnings outside of these conditions are subject to income taxes and a 10% penalty.
Traditional IRA withdrawal rules
Because Traditional IRAs are tax-deferred accounts, withdrawing funds will result in paying taxes on any pre-tax contributions and earnings. The goal in withdrawing funds is to avoid the 10% penalty that applies if you don’t meet certain conditions. If you meet any of these conditions you can avoid the 10% penalty:
- Age 59 1/2 years old
- Using funds to pay for qualified higher education expenses for you or immediate family members. Qualified expenses include tuition, books, fees, and room and board (for students attending at least half time)
- Using funds to pay for a first time home purchase (up to $10,000)
- Using funds to pay for birth or adoption of a child (up to $5,000)
- Using funds to pay for medical expenses and health premiums that exceed 7.5% of your adjusted gross income
- If you become disabled
- Your beneficiaries withdraw funds upon your death
Early IRA withdrawals
Withdrawals taken before age 59 1/2 will result in taxes and a 10% penalty. This applies to earnings and contributions from Traditional IRAs and earnings from Roth IRAs.
For the official IRS rules about withdrawals, see the IRS’ IRA website.
Required minimum distributions (RMD)
The IRS allows you to defer taxes on Traditional IRAs for a period of time but not indefinitely. A required minimum distribution (RMD) is the way the IRS rules force individuals to begin taking withdrawals and paying taxes.
RMDs are the amount of money a Traditional IRA plan owner or participant must withdraw from their account at certain ages. As of 2020, withdrawals must begin the year the account owner reaches 72 years old. The minimum amount that must be withdrawn that year and each year thereafter is defined by the IRS. Additionally, if you inherit an IRA you may be required to take RMDs.
Note, prior to 2020, the RMD age was 70 1/2 years old. Also, RMDs have been waived for 2020 as part of the CARES act / COVID-19 relief.
Charles Schwab has a fantastic RMD calculator to estimate minimum withdrawals.
What can you invest IRAs in?
Funds within a Traditional or Roth IRA can be invested in almost any type of investment asset. This includes stocks, bonds, ETFs, mutual funds, and some derivatives (options).
Direct real estate investments (for non personal use) can be invested in, but you will need some expert counsel on setting up this more complicated type of IRA. Other non-traditional types of investments, such as collectibles and life insurance, are not permissible. Additionally, derivatives (options) that have unlimited risk, such as selling naked calls, are not permissible. Use of margin (borrowing) is also not allowed in IRA accounts.
Rollovers
There are two types of rollovers related to IRAs
- Rollovers from retirement accounts like 401(k) or 403(b) accounts
- Rollovers between IRA accounts
If you’ve left a job where you had a 401(k) or 403(b) account, you can “rollover” your work retirement account to a Traditional or Roth IRA, depending on if the retirement account contributions were pre or post tax.
You can also rollover a Traditional IRA to a Roth IRA account. To do this you must pay taxes on amount, but then your earnings will grow tax free.
I’ll cover both of types of rollovers in more detail in a future post.
How to setup an IRA
Most brokerages, banks, and credit unions offer IRAs. I recommend using a brokerage over a bank or credit union because there are more investment options for your account and the user interface and apps are generally better.
How to use IRAs to build wealth
Both Traditional and Roth IRAs are a great tool for building wealth. Compared to each other both have their advantages and disadvantages, but both provide better tax advantages than regular brokerage accounts.
If you’re ready to start building wealth using an IRA, get started by opening up an account, begin making contributions, and read more on how to invest and grow your money with the recommended articles below:
How to start investing (4 step beginners guide)
How to build a diversified investment portfolio
How to start investing in your 20s
