IRAs 101: Intro to Individual Retirement Accounts

Individual retirement accounts (IRAs) are tax-advantaged investments intended to help you boost your retirement savings. Most types of investments can be registered as IRAs, including money market accounts, mutual funds, stocks and bonds. The two primary types of IRAs are traditional and Roth. Both are designed for long-term growth, but there are key differences, including how and when they are taxed. Here is a general overview of the two accounts and some suggestions on how to choose the one that’s right for you.

Traditional IRAs

In 2021, anyone age 18 and older can contribute the lesser of $6,000 or an amount equal to their taxable compensation to a traditional IRA. Those age 50 and older can contribute up to $7,000. Contributions may be tax-deductible, and grow tax deferred. You may begin making penalty-free withdrawals at age 59½, and you must begin taking required minimum distributions at age 72. Withdrawals are subject to income tax, and early withdrawals before age 59½ may be subject to a 10 percent tax penalty.

Your ability to deduct contributions to a traditional IRA is dependent on your income. Married couples filing jointly with a modified adjusted gross income (MAGI) of up to $105,000 can deduct the full amount, as can single filers with a MAGI of up to $66,000, if not covered by a retirement plan at work. If you exceed these income limits you can still deduct a pro-rated portion of your contribution until eligibility is phased out for singles making $76,000 or more and couples making $125,000 or more.

Roth IRAs

Contributions to a Roth IRA are made with after-tax dollars, and money inside the account grows tax-free. The annual contribution limit for a Roth IRA is also $6,000, or $7,000 for those age 50 and older (or an amount equal to the individual’s taxable compensation if it is less than these amounts). 

If you are over age 59½, you can withdraw funds penalty-free at any time and there are no minimum required distributions at age 72, as is the case with traditional IRAs. And regardless of age, you can withdraw your already-taxed contributions at any time penalty-free. It is important to note, however, that you must wait five years after your first contribution to a Roth IRA to withdraw your earnings tax free – even if you are 59 ½ or older at the time of the withdrawal. The five-year period starts on the first day of the tax year for which you made a contribution to any Roth IRA, even if it’s not the Roth IRA from which you are withdrawing.

There are a few exceptions to these rules. For example, you can take money out of your Roth IRA without the early withdrawal penalty when it’s used for a first-time home purchase, college expenses, certain medical expenses and birth or adoption expenses. For a complete list of exemptions, be sure to consult with your Financial Advisor.

Married couples filing jointly must have a modified adjusted gross income (MAGI) of less than $198,000 to make full contributions to Roth IRAs and single filers must have a MAGI of less than $125,000. If you exceed these income limits, you can still make partial contributions until eligibility is phased out for joint filers at $208,000 and single filers at $140,000.

Is a Roth IRA or traditional IRA best for you?

The main difference between a traditional IRA and a Roth IRA is how and when contributions are taxed. You can deduct contributions to a traditional IRA and possibly lower your taxable income for the year in which you made the contributions, but you will have to pay ordinary income taxes when you withdraw your money in retirement. Roth IRAs don’t offer immediate tax benefits — you make contributions with after-tax dollars — but withdrawals are tax-free.

When choosing between the two accounts, the best choice for you likely depends on whether you think your tax rate will be higher or lower in the future. If you anticipate a higher tax rate in retirement, a Roth IRA may be the better choice, since withdrawals are tax-free. And if you expect a lower income tax rate in retirement, a traditional IRA may offer you more tax advantages since you may be able to lower your taxable income now and pay a lower income tax rate on withdrawals in the future.

You don’t necessarily have to choose between the two accounts; It is also possible to hedge your bets by contributing to both. Contribution limits are cumulative across accounts, so total contributions cannot exceed $6,000 ($7,000 for those 50 and older) in 2021.  

Whether you choose to fund a traditional IRA, Roth IRA or both, you’ll be taking advantage of tax benefits that can help you more effectively pursue your retirement goals. Rethinking Retirement Planning has additional retirement planning tips to consider. And be sure to consult with your Financial Advisor for help navigating financial planning options in coordination with your military benefits.

First Command does not provide legal or tax advice, and this article does not contain any legal or tax advice.  Should you require legal or tax advice, you should consult with your attorney or tax advisor.  The information provided to you herein is provided for informational purposes only, is not intended to be tax advice, and should not be used for the purpose of avoiding tax-related penalties under the Internal Revenue Code.