When it comes to saving for retirement, there are a few different strategies and accounts that investors can utilize to meet their goals. One such account is the individual retirement account (IRA).
There are two primary types of IRAs to choose from: a traditional IRA and a Roth IRA. Both provide future retirees with the ability to save in tax-advantaged accounts. The idea behind these accounts (and their tax benefits) is to encourage future retirees to save.
“An IRA is a way for the government to get people to save money for retirement,” says John DeYonker, head of investor relations for Titan. They give this tax-advantaged status to these accounts, which you really don't get anywhere else, to force people to save. Because—hopefully—you're not relying on the government for retirement.”
Here’s a look at what these two IRA types offer, some of the biggest IRA advantages and disadvantages, and how to determine which one may be most suitable.
What are the main benefits of an IRA?
IRAs can be invested almost anywhere—and the investor gets to choose where. An IRA can be opened at any number of financial institutions, including banks, brokerages, and credit unions.
These savings can be invested in assets of the account holder’s choosing, including stocks, bonds, certificates of deposit (CDs), exchange-traded funds (ETFs), mutual funds, and even real estate. This is far more flexible than an employer-sponsored 401(k) plan, where investors are stuck with whatever investment options (and fees) their workplace offers.
Then, there are additional benefits depending on the type of IRA chosen.
Traditional IRA benefits
With a traditional IRA, investors get to enjoy upfront tax deductions. Similar to a 401(k) plan, these pretax traditional IRA contributions can be deducted from taxable income in the year that they are made, as long as an investor meets certain income limits.
In that same vein, traditional IRAs defer the taxation of savings until retirement, when the funds are withdrawn as ordinary income. Why does that matter? Well, if an investor is in a higher tax bracket today than the one they expect to be come retirement time, choosing a traditional IRA can allow them to defer taxes until they drop to that lower bracket.
For current high earners, these savings can be significant.
Roth IRA benefits
A Roth IRA works the opposite way. With this account, an investor contributes today with after-tax money, at their current tax rate. However, the money will grow tax-free and once they reach retirement, they can take withdrawals (on both the contributions and any growth) without paying additional taxes.
If an investor expects to be in a higher tax bracket in retirement than the one they’re in now, this can mean notable savings. By contributing money today, they lock in their current tax rate for contributions and eliminate having to pay taxes on their gains over the years. Even if they were to reach the highest tax bracket in retirement, their Roth IRA withdrawals will be tax-free.
Another one of the key benefits of a Roth IRA is that there are no required minimum distributions (RMDs). With traditional IRAs, RMDs begin at age 72; however, with a Roth IRA, there is no minimum withdrawal required, regardless of an investor’s age. If someone were to die and pass the account on to a beneficiary, they would be subject to required withdrawals.
Additionally, because Roth IRAs are funded with after-tax dollars, there are no penalties for withdrawing contributions any time before retirement. It’s important to note that this only applies to contributions; if a person withdraws any earnings before retirement, they could still be subject to both taxes and a 10% early withdrawal penalty.
Drawbacks of an IRA account
Depending on the type of IRA and an investor’s financial plan, there are also few drawbacks to keep in mind.
- Roth IRA contributions are not tax-deductible. Both traditional IRA and 401(k) savings contributions are deductible. This means that they can help reduce investor’s taxable income in the year they’re contributed. However, contributions to a Roth IRA are not tax-deductible, so there is no benefit recognized initially.
- Traditional IRAs are subject to RMDs. If an investor has a traditional IRA, they will be required to start taking withdrawals (called RMDs) once they reach age 72. If they fail to withdraw the minimum required amount annually, they may be subject to penalties.
- IRAs have low(er) contribution limitations than other retirement plans. Unlike 401(k) plans—which allow for annual contributions up to $20,500, beginning in 2022—IRAs have much lower limits. Even if an investor contributes to more than one account, they’ll only be allowed to tuck away a total of $6,000 into IRAs in 2022. (Those over age 50 can contribute up to $7,000.)
- Your savings are (typically) locked away until retirement. Unlike a brokerage account or high-yield savings account, the money put into an IRA is specifically earmarked for retirement. Withdrawing your traditional IRA contributions before age 59½ usually results in early withdrawal penalties, and withdrawing gains before age 59½ from any IRA account can also trigger income and penalty taxes.
There are a few exceptions: contributions can be withdrawn from a Roth IRA at any time without penalty — you just can’t touch your gains before age 59½. Funds can also be withdrawn from an IRA if they’re being used to pay medical insurance premiums after losing workplace coverage.
The bottom line
An IRA is a retirement savings tool that can offer additional investment and growth opportunities for an investor’s’ future. Whether an investor chooses a traditional IRA or a Roth IRA comes down to factors like their income, current, and future tax brackets, and their liquidity preference.
