IRAs Explained: Traditional and Roth IRA Information, Similarities, and Differences

As I had mentioned in the retirement planning resources section of my blog, I've been getting questions from friends and family lately that brought me to a realization. The general public does not understand the basics of Individual Retirement Accounts, or IRAs, one of the most common retirement planning vehicles available in the US. Coming from an education in a business and finance related field, I took for granted the fact that I had a good understanding of the rules, tax advantages, and strategies of IRA accounts. After realizing this, I felt that it would be best to attempt to share my knowledge in an easy to read format - for a quick 'cheat sheet' of everything you need to know to get started thinking about IRA accounts, see here. 

To add a bit more commentary and color to these quick 'cheat sheets', I decided it was best to get all my thoughts in an article. So without further adieu, let's take a dive into the details of IRAs.

The Two Main Types - Traditional and Roth

As many may already know, there are two main types of IRA accounts - Traditional and Roth. I'll go into further detail on each type below, but there is one main difference that separates these two types, and it has to do with each account's unique tax advantage. See below. 

Traditional IRA contributions (money put in now) are made with tax-free dollars, and distributions (money taken out later) are taxed as ordinary income. 

Conversely, Roth IRA contributions are made with after-tax dollars, but distributions are not taxed.  

Got it? Good! Now let's move onto the nitty gritty for each type. 

Traditional IRA Accounts - The Basics

As noted above, traditional IRA accounts are funded through individual contributions that are tax-deferred. A little confused still? Think about it like the 401(k) account you have at work - any money you put (or tell your employer to put) into your 401(k) is backed out of your taxable income. A traditional IRA (I'll refer to this type as just "IRA" from here on out) works the same way, except it is not connected in any way to your employer. So let's say, for any reason, you're not eligible to participate in your employer's 401(k) plan yet - you can still open and contribute to an IRA to get the same type of tax benefit. 

Once contributions are made, YOU control where the money is allocated. While the general route is to allocate contributions into mutual funds (which, if your mutual fund tracks an index like the S&P 500, this is not a bad choice), you can also choose to invest in ETFs, stocks, REITs, etc. - basically any investment you'd typically have access to in a brokerage account. Then - and this is the IMPORTANT part - your earnings then compound tax-free. 

Every dividend, every capital gains distribution, TAX-FREE. That might not sound extremely significant, but if you start to contribute to an IRA account early on in your life, this just lets the power of compounding do its job even better. 

When you're ready to take distributions, you are then taxed as ordinary income, assuming you meet the criteria for the distribution to be considered "qualified". I'll get into these rules in the section below. 

So to summarize, the basic things to remember about Traditional IRA accounts are the following:

• Contributions are made tax-free
• Earnings compound tax-free
• Distributions are taxed as ordinary income

Easy enough? Good! Now for more detail. 

Traditional IRA Accounts - Rules & the Rest

As of the 2020 tax year, the maximum amount a typical individual can contribute to a traditional IRA account (or simply "IRA") is $6,000. However, there are some exceptions if you meet certain criteria. For example, individuals over the age of 50 are eligible to make an additional "catch-up" contribution of $1,000 on top of the $6,000 limit. Also, in order for you to make contributions in the first place, you must have earned income greater than, or equal to, the amount of your contribution. You'll see later that Roth IRA contributions are subject to the same limitation amounts. 

There is no income limit that would preclude you from contributing to an IRA, but as you will see discussed later, there are income levels that will limit the tax-advantaged status of contributions. 

We compared an IRA to a 401(k) plan earlier in terms of tax advantages. Another way an IRA is similar to a 401(k) account is the timing of when you can begin to take distributions from the account without paying a penalty (also referred to as a "qualified distribution"). For the most part, to make a qualified distribution, you must wait until the age of 59 1/2 to avoid paying a 10% penalty in addition to the tax you'll normally pay upon distribution. However there are certain situations where you can avoid this penalty before the age of 59 1/2. To make an early distribution without penalty, your distribution must be used for/upon occurrence of one of the following: a first-time home purchase, qualified educational expenses, death, disability, unreimbursed medical expenses, health insurance (if unemployed), or upon birth or adoption of a child (up to $5,000). 

Other Traditional IRA Rules

While the above section sums up the most commonly relevant rules attributable to a traditional IRA account, there are some other rules to keep in mind. These are summarized below. 

Limitation of Tax Advantaged Status of Contributions: As noted earlier, while there is no income limit to contribute to your IRA account, if your modified adjusted gross income (MAGI) is over $65,000 ($104,000 for married filing jointly) in tax year 2020, you will not get the full tax-free status of your contribution. The tax-free status is phased out completely when you reach a MAGI of $75,000 ($124,000 for married filing jointly). However, even as the tax-advantaged status of the contribution is phased out, your earnings will still compound tax-free. 

Required Minimum Distributions: On traditional IRA accounts, you will be required to take certain amounts, calculated based on your age and IRA balance, as a distribution, whether you want to or not. This is the IRS' way of saying, "Hurry up! We want your taxes already!"

I know this section was a bit more lengthy, but here's another quick traditional IRA summary to add to the first. 

• Contribution limit for most individuals is $6,000
• There is no income limit to contribute to an IRA account
• Your income can affect the tax-advantaged status of contributions
• Qualified distributions begin at age 59 1/2, unless you meet specific criteria listed above
• Required minimum distributions (RMDs) begin at age 72

Now onto the other type, Roth IRAs. 

Roth IRA Accounts - The Basics

While we compared traditional IRA accounts to a typical 401(k) account in terms of tax timing above, a Roth IRA works a bit differently. 

Contributions made on Roth IRAs are made with after-tax money. Earnings still compound tax-free, and then qualified distributions are taken tax-free. So while you get your tax benefit on the front end in the case of a traditional IRA, you get it on the back end in the case of a Roth IRA. Similarly to the section above, I'll summarize the basic points below for. 

• Contributions are made after-tax
• Earnings compound tax-free
• Distributions are taken tax-free

Now again onto the more gritty details.

 

Roth IRA Accounts - Rules & the Rest

From here on out, I'll focus mainly on the differences Roth IRAs have compared to traditional IRAs, as the two accounts do have a lot of similarities. For example, both types of IRA accounts share the same contribution limits ("catch-up" contributions included), age requirement for qualified distributions, and the same 10% penalty for unqualified distributions. Further, the types of investments you can hold within a Roth and traditional IRA are the same as well. 

Unlike a traditional IRA, there is an income limit that precludes you from contributing to a Roth IRA. In tax year 2020, to be eligible to make the full $6,000 contribution amount, you must have modified adjusted gross income (MAGI) of less than $124,000 ($196,000 for married filing jointly), and the contribution eligibility is phased out completely at a MAGI of $139,000 ($206,000 for married filing jointly). 

Another difference is that you are able to withdraw contributions at any time, penalty and tax free, since these have already been taxed. Keep in mind, however, that withdrawing earnings prior to the age of 59 1/2 will result in a penalty.

One more difference to note regarding a Roth IRA - there are no required minimum distributions (RMDs) during the original account owner's lifetime. 

So, again to summarize:

• Contribution limit for most individuals is $6,000 (same as traditional IRA)
• There is an income limit to contribute to an Roth IRA account, beginning at $124,000 and phasing out completely at $139,000 for single filers (different from traditional IRA)
• Qualified distributions begin at age 59 1/2 (same as traditional IRA), but you can withdraw contributions at any time (different from traditional IRA)
• There are no required minimum distributions (RMDs) during the original account owner's lifetime (different from traditional IRA)

Summary

In summary, an IRA account is a great way to begin preparing for retirement outside of your typical employer-based plan, such as a 401(k). The two main types, traditional and Roth IRAs have different tax advantages to be considered when opening, as discussed above. 

With the amount of information presented above, it may be helpful to download a copy of my FREE traditional and Roth IRA cheatsheets, which can be kept on hand the next time you have any questions or confusion regarding IRA accounts. 

As always, if you have any further questions, or think I left something out that I should have included above, please drop a comment below and let me know!

- FI Anon