Financial bloggers present the debate between the 401(k), or traditional IRA, and the IRA as if they were comparing the two plans.
They are very different plans that serve very different purposes. If you’re able, it is best to plan for both.
It is particularly true if you have a 401(k). Many of them do. The fees are high and the investment options are limited. Traditional IRAs are often the best way to avoid these limitations.
Take a look at the two plans and see where they differ. You’ll probably agree that having both plans makes sense. This is one of the most effective strategies for boosting your retirement savings.
Roth IRA vs Roth 401k – Which One is Better?Roth IRA vs Roth 401k – Which is the best? Ask the CFP(r).
The Traditional IRA: How it Works
Here are some basics:
Limits on IRA contributions. Contributions are limited to $6500 annually, or $7500 for those over 50. Earned income is defined as wages, salaries, commissions or self-employment. This does not include unearned income, such as pensions, social security or investment income.
If you earn $40,000 and only $4,000 of that is earned, then your IRA contribution can’t exceed $4,000.
Spousal IRA Provision. When you are married filing jointly and one spouse has income and the other does not, you may qualify to make a spousal IRA. Only one requirement must be met: the spouse who has earned income needs to have enough income to cover both plans.
Let’s say, for example, that you earn $50,000 a year and your spouse has no job. You can contribute $6,500 to your own IRA and $6,500 to a spousal IRA. This will give you an overall contribution of $13,000 which is also fully tax-deductible.
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Require Minimum Distributions (RMDs).
Traditional IRAs, like all other retirement plans – except Roth IRAs – are subject to RMD regulations. You must begin receiving distributions when you reach 72 years old.
Distributions are usually based on the remaining life expectancy. The percentage of your plan that is distributed will rise slightly as the life expectancy decreases with each passing year. The IRS expects to receive its tax revenue if you exhaust your plan before the end of your life.
Tax Deductibility for Traditional IRA Contributions
Contributions to a traditional IRA are fully tax deductible for most taxpayers. It is true if neither you or your spouse have a retirement plan sponsored by their employer. There is no income limit for the tax-deductible contribution to a traditional IRA if you or your spouse are not covered by an employer’s plan.
Tax deductions may be reduced or even eliminated if you fall into either category.
When you or your spouse is covered by an employer’s plan, the tax-deductibility of a traditional IRA contributions depends on your adjusted gross income. This is your adjusted gross for tax purposes with some modifications.
If you are covered by a plan sponsored by your employer, you may still contribute to a traditional IRA. The MAGI level will determine the tax-deductibility of the contribution.
- Contribution is fully deductible for singles or heads of households up to an MAGI of $65,000 ($64,000 in 2019); the deduction gradually decreases up to $75,000; beyond that, it disappears completely.
- If you are married filing jointly or if you qualify as a widower, the full deduction is available up to an MAGI of $104,000. This is up from $103,000. The deduction gradually decreases up to $124,000.
- Contribution for married filing separately is phased out until MAGI reaches $10,000. After that, it disappears completely (no changes from 2018 to 2019.
If the numbers are different, then You’re not covered under an employer-sponsored pension plan, but your spouse may be. . The MAGI limit will determine whether your IRA contribution can be deducted for tax purposes.
- Married filing jointly: fully deductible for MAGI up to $196,000; phase-out up to $206,000 by 2020 (both higher than 2019) and then disappears.
- The contribution of a married couple filing separately is phased out after a MAGI amount of $10,000. After that, he disappears completely.
Additional IRA Tax Considerations
Investment income tax deferral. Whether your contributions to a Traditional IRA are tax deductible or not, the investment income you accumulate is always tax deferred. You can invest without having to worry about the tax implications. Even if you don’t deduct your contributions, tax-deferred income from investments is still worth it. Tax deferral will allow your investment nest egg to grow faster than without it.
Your investment will continue to grow tax-deferred until you start making withdrawals.
Withdrawals from IRAs are taxed. Taxes on IRAs are not due until withdrawals begin. Withdrawals can be made starting at age 59 1/2. They will be subjected to ordinary income taxes.
You will not have to pay tax on any portion of your distribution if you did not make any contributions which were not deductible due to income restrictions.
If you have $100,000 in your IRA, with $60,000 of accumulated investment income and $30,000 of tax-deductible contributions as well as $10,000 of non-deductible contributions in the account, 10% of any withdrawals will be exempt from income tax.
If you withdraw $10,000 from your account, $9,000 of that amount will be taxed. The remainder of $1,000 ($10,000 x 10%) will not be taxable. This is known as the IRS Pro Rata Rules. You will not be able declare that the first 10,000 dollars withdrawn from your plan represents your nondeductible contributions.
Early Withdrawal Treatment
You will be charged a 10% penalty if you withdraw money from a traditional IRA prior to turning 59 1/2.If you are in the federal income tax bracket of 12% and make a $10,000 withdrawal early from your plan, then you will have to pay tax of $2,200. This is 12% ordinary tax plus the 10% penalty for early withdrawal.
The IRS has a listing of exceptions from the penalty. You will be required to pay ordinary tax on the amount you withdraw.
Traditional IRA Investments
Self directed investing. With an IRA, whether traditional or Roth, you have total control over your account. You can build your own portfolio and choose the investments to make it, as well as buy and sell securities at your own pace.
Account Trustees. Choose any trustee platform that you like. You can select any of the following trustees as the plan’s holder:
- High interest rates are paid by a bank, especially an online bank
- Investment brokerages, like E*TRADE
- Managed funds or Investment Accounts
- Families of mutual funds or exchange traded fund (ETF)
- Robo-advisors like Betterment, wealthfront or Ally Investment
- Platforms like Lending Club and Prosper are peer-to-peer lending platforms.
- Real estate investment trusts (REITs)
- Platforms like Peerstreet Fundrise and RealtyShares
Check out these top Roth IRA accounts if you are looking for a Roth IRA.
Options for investment. More good news. In a traditional IRA, you can choose to hold any investment. The IRS maintains a very brief list of prohibited investments. These are generally not the types you’d buy.
You can invest in a variety of ways – use your imagination. mutual funds, ETFs target dates funds, individual stocks, bonds, certificates, options, gold and foreign currencies, real estate investment trusts and certificates of deposit.
The traditional IRA offers a great alternative to 401(k), which has limited investment options.
Converting Roth IRAs
The Roth IRA conversion is a must-discuss in any discussion about a traditional IRA. Both IRAs and 401(k), plans can be converted. It’s easier to convert an IRA, since it is a self-directed account. Some employers allow IRA conversions when you are still working, but most require you to remain in your 401(k).
Why do a Roth IRA conversion? Roth IRA is the only Roth IRA (alongside Roth 401(k), Roth 403(b), and so on). Tax-free income is available in retirement. The plan works like a traditional IRA, in that the income is tax deferred. The contribution limits are the same.
Contributions to a Roth IRA are not tax deductible . If you are 59 1/2 and have been a member of the plan for at least five years, you can take tax-free distributions. This includes both distributions from your contributions as well as your investment earnings.
There is no limit to the amount you can convert from your retirement account into a Roth IRA. By converting $100,000 from your IRA or 401k, you can quickly build up your Roth account.
Roth IRAs and Roth IRA conversions of other retirement plans have become very popular.
What are the tax implications of a Roth conversion?
You will have to pay tax on your converted amount. There is no penalty for early withdrawal, even if you convert before the age of 59 1/2.
Say you are in the federal income tax bracket of 22%. You convert $100,000 of a traditional IRA into a Roth IRA. You will pay $22,000 in the year of conversion – $100,000 multiplied by 22%. Once you’ve done this, and met the Roth IRA plan age and length requirements, then you can start taking tax-free distributions.
This is a summary of a Roth IRA. In my Roth IRA Conversion article, I delve into this topic in great detail.
The 401(k), How it Works
The basics of 401(k)s:
Contributions to 401(k).
Limits on 401(k). In 2023 the limit for 401(k). is $22,500. This is an increase of $2000 over 2022. The catch-up contribution has also increased by $1000 since 2022 to $7,500. If you are 50 years old or older, then your contribution could be up to $30,000 per year.
Matching contribution by the employer. Most employers, especially large ones, provide some form of matching contribution. If they match 50% and you contribute 10%, your total contribution is 15%.
According to the Society for Human Resource Management , 42% of companies will match dollar for dollar on 401(k).. If you contribute 10% and your employer matches 100%, then your total contribution is 20%.
vesting rules apply to employer matching contributions. The vesting period is the amount of time that passes before you are considered the owner of the employer match. It can take between two and six years, depending on the vesting plan used, to become fully vested.
The combined contribution to a plan by you and your employer could be up to $66,000 in 2022, an increase of $5,000 over last year.
The 401(k). Easy funding of a plan. It’s an employer-sponsored plan, so your contributions will be made automatically through payroll deductions. It is the easiest way to fund an investment program. You only need to select the percentage of your contribution and then let it flow into your account. If your employer matches your contribution, they will usually match your contributions.