Traditional IRA vs. Roth IRA
Traditional IRAs are best for people who want that immediate tax break to defer income because their tax bracket will likely be lower in the future, such as those expecting to retire soon. You may be able to deduct your IRA contributions even if you or your spouse are covered by another retirement plan at work. Your traditional IRA contribution will reduce your adjusted gross income (AGI) dollar for dollar, which may even make you eligible for other tax breaks tied to income.
There is no upfront tax break for funding a Roth IRA, but for younger people in lower tax brackets, or those with 401(k) plans that have high costs or no employer matching, a Roth IRA may be the way to go. Unlike traditional IRAs, as Roth IRA funds have already been taxed, you won’t pay taxes on distributions from Roth IRAs that you take in retirement. In addition, Roth IRAs have no annual required minimum distribution requirement, allowing for more flexibility. There are many things to consider when choosing between a Roth IRA, a traditional IRA, or a 401(k), and for many, it may be a good idea to have a combination of these accounts. If you’re unsure, let a professional run the numbers for you.
Income Limits for Tax Deduction
If you’re single and don’t participate in your retirement plan at work, you can make a tax-deductible traditional IRA contribution of up to $6,000 ($7,000 for those fifty or older) regardless of income.
If you’re married and your spouse contributes to a retirement plan at work, but you don’t, you can deduct your full IRA contribution as long as your combined adjusted gross income is below $196,000. You can take a partial deduction if your AGI is between $196,000 and $206,000.
If you do participate in a retirement plan at work, you can still deduct up to the maximum $6,000/$7,000 IRA contribution if you’re single and you make less than $65,000 ($104,000 for married couples filing jointly). Partial deductions apply for singles who make between $65,000 and $75,000 (between $104,000 and $124,000 for married couples filing jointly).
“Backdoor” Roth IRA Contributions
For high earners, a “backdoor” Roth IRA is a way to sneak past the income limits that apply to making contributions to a Roth IRA. For 2020, you can fully contribute to a Roth IRA if you’re single and your AGI is under $124,000 ($196,000 for married couples filing jointly). Once a single taxpayer’s income exceeds $139,000, they are ineligible to contribute to a Roth IRA ($206,000 for married couples filing jointly). Between $124,000 and $139,000, a single taxpayer can make a partial contribution ($196,000 to $206,000 for married couples filing jointly).
However, as there are no income limits on Roth conversions, you can make a “backdoor” Roth contribution by contributing to a traditional IRA, and then “converting” those funds over to a Roth IRA. In essence, this allows individuals who are otherwise ineligible to contribute to a Roth IRA to fund a Roth IRA account. As the tax-free growth that Roth IRAs provide is extremely beneficial, all investors should consider the possibility of making a “backdoor” Roth contribution.
Be aware, however, that the “backdoor” Roth contribution strategy usually only works well when you have no funded (or minimally funded) traditional IRA accounts. The existence of a currently funded traditional IRA creates potential negative tax consequences, so you would want to consider this before making a “backdoor” Roth contribution.
When weighing the pros and cons of any type of retirement contribution, there are too many considerations to list here. As always, the best plan of action is to talk to your trusted financial advisor to see how each option fits into your long-term financial strategy.
DISCLOSURE Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal. Diversification does not eliminate the risk of market loss. A long-term investment approach cannot guarantee a profit. Adviser is not licensed to provide and does not provide legal, tax, or accounting advice to clients. Advice of qualified counsel or accountant should be sought to address any specific situation requiring assistance from such licensed individuals.