With the number of IRAs at your disposal, it’s very easy to get lost in the details. Here, we’ll iron out some of the more common points of confusion when it comes to the different IRA types and offer guidance on when certain IRAs are better than others.
In this article, you’ll find answers to the following questions:
There is often some confusion around how an IRA, or Individual Retirement Account, fits into one’s total financial picture. First, it’s critical to remember that a 401(k) is explicitly tied to your employment – that is, you open a 401(k) as part of your employment status (if you’re a sole practitioner, a Solo 401(k) can be utilized as your very own “employer” plan – even if you’re your own boss).
An IRA (at least those of the traditional or Roth variety) is opened on your own, outside of your employment relationship, and at a provider of your choice. Keeping your IRAs and 401(k)s psychologically separate is not only a good financial planning technique – it’s also an accurate reflection of reality.
401(k)s have significantly higher contribution limits than IRAs. Through your employer, you’re able to contribute $22,500 to your company’s 401(k) plan in 2023, and if you’re over 50, you can contribute another $7,500. IRAs, in contrast, come with lower contribution limits; in 2023, you’re able to contribute up to $6,500 if you’re under age 50, and up to $7,500 if you’re over age 50.
To settle any confusion, these limits apply to direct contributions, but not rollovers. This means you’re not limited in the amount you can roll from a 401(k) to an IRA.
One of the most common types of IRAs is the traditional IRA. Traditional IRAs are meant to hold pre-tax dollars, meaning that you may receive a deduction on your tax return for any money you contribute – keep in mind, however, that you may not be able to take a deduction if you have a retirement plan at work or if you earn more than the IRS-designated limits.
With a traditional IRA that holds pre-tax dollars (you received a tax deduction for any money you contributed), you’ll avoid paying any tax on growth or earnings in the account until you withdraw money in retirement. When you finally do take money out of the account, it will be taxed at your ordinary income tax rate in retirement – so be careful before you withdraw!
Traditional IRAs can also be known as any of the following, but there are some technical details associated with all types:
An IRA that behaves similar to a traditional IRA, but you never received any tax deduction for money contributed. In essence, the money you contribute to a nondeductible IRA is considered “after-tax”, which means you’ve already paid tax on it and should not be taxed on the money when you withdraw it in retirement. However, any growth or earnings associated with nondeductible contributions will be taxed upon withdrawal.
An IRA containing money that’s been “rolled over” – another way to say “moved” – from a previous employer or another IRA provider. A rollover IRA may be a traditional IRA, but it doesn’t necessarily need to be; this depends on the tax-status of the money moving over.
The spousal IRA, which can be either traditional or Roth-labeled, exists for the benefit of families with a non-working spouse. As long as the working spouse earns enough to cover the contributions of both spouses, and the couple files taxes jointly, the Spousal IRA can be a meaningful way to increase retirement savings and to receive additional tax benefits.
A somewhat-unique IRA set up by your employer. A SEP-IRA is not open to employee contributions via salary deferral like a typical workplace 401(k) plan. In 2023, your employer can contribute up to 25% of employee compensation or $66,000, whichever is less. Small employers looking to maximize contributions, minimize cost, and limit plan setup complications may opt for a SEP-IRA.
A less common, employer-sponsored IRA similar to a SEP-IRA, but with lower contribution limits ($15,500) and an option for employees to contribute. SIMPLE IRAs, at their core, operate as traditional IRAs from a contribution, investment, and distribution standpoint – but are typically found in companies with less than 100 employees that want to give contribution rights to their employees.
Another less common IRA available as both a traditional or Roth IRA. Self-Directed IRAs are special IRAs set up to accommodate alternative investments or closely held businesses. Typically, those seeking Self-Directed IRAs are more seasoned investors who want a broader menu of investment choices and are willing to take a bit more risk.
The above accounts may be treated as traditional IRAs, but some – like the nondeductible IRA and the rollover IRA – may contain funds that are excepted from the standard traditional IRA rules.
This is all to say that you’ll need to be especially careful to understand the tax status of all money that goes into and out of your IRA, most notably if the money is “pre-tax” or “after-tax”. Keeping pre-tax money separate from after-tax money is one of the simplest ways to keep your financial planning clear in your mind.
The second major category of IRAs is the Roth IRA. Roth IRAs, in contrast to traditional IRAs, hold only after-tax money; in other words, any money contributed to your Roth IRA has already run through your tax return for the current or previous year.
On one hand, you’ll pay tax at today’s rates; on the other, once money hits your Roth IRA, you’ll have a zero tax liability on the account as a whole – for the rest of your life.
This means you’ll never pay tax again on any growth or earnings, and you’ll never have to worry about tax planning for your Roth IRA later in life. A pretty nice set of benefits indeed.
|IRA Type||Contribution Limit (2023)||Tax Status||Best For|
|Traditional IRA||$6,500 ($7,500 if over 50)||Pre-tax if the contributor receives a tax deduction||Married people with income less than $116,000, single people with income less than $73,000, or anyone who wants to roll over an old retirement account|
|Roth IRA||$6,500 ($7,500 if over 50)||After-tax||Anyone with earned income, but mainly those who anticipate a higher tax rate in retirement or anyone who needs to roll over an old retirement account|
|Nondeductible IRA||$6,500 ($7,500 if over 50)||Contributions are considered after-tax, growth and earnings considered pre-tax.||People who earn too much to contribute directly to a Roth IRA or deductible traditional IRA|
|Spousal IRA||$6,500 ($7,500 if over 50)||Pre-tax if the contributor receives a tax deduction||Non-working spouses whose partner earns enough to cover both spouses’ contributions|
|SIMPLE IRA (workplace plan)||$15,500 ($18,500 if over 50)||Pre-tax||Small employers (<100 employees) who wish to allow employees to contribute|
|SEP-IRA (workplace plan)||25% of employee compensation or $66,000||Pre-tax||Small employers who want to maximize contributions|
|Self-Directed IRA||$6,500 ($7,500 if over 50)||May be either pre-tax or after-tax||Investors looking for access to alternative investments|
Many people have turned to robo advisory firms, like Betterment or Wealthfront, to help them manage their investments. It’s important to remember that these firms are investment managers, and not account types; in other words, they help people automate and manage their investments at very low cost, but they are not account types unto themselves.
In other words, robo advisors are one of many solutions available to help you manage your traditional or Roth IRA. In fact, many investors choose to handle their investments on their own at zero cost.
Traditional and Roth IRAs are likely going to be the two you’re grappling between – even though it’s also possible you have access to any of the IRAs mentioned earlier.
Traditional IRAs are really intended to hold pre-tax dollars; that is, similar to your pre-tax 401(k) plan, you deposit money and receive a tax deduction for the same year – assuming you meet certain income and household requirements.
What does it mean to get a tax deduction? It means that the amount you contribute to your traditional IRA is “deducted” from your gross income. In other words, by contributing to a traditional IRA and receiving a deduction, you decrease your accounting income and as a result will owe less tax for the year. This is a good thing, by most standards.
After you contribute to a traditional IRA – and perhaps most importantly, after you invest the money – you’ll benefit from tax-deferred growth and earnings in the account. Put another way, you won’t have to worry about any further taxation until you remove money from the account, ideally in retirement.
The traditional IRA, in theory, works best for people who earn less than a certain income (less than $73,000 as a single filer and less than $116,000 as a married filer) and at the same time expect their tax rate to be lower in retirement. These numbers are eclipsed in the 22% federal tax bracket, so if you fall below this threshold, you might look into a deductible traditional IRA. It’s also a great option to roll over your old employer-sponsored retirement account, like a 401(k).
This way, you receive a deduction at higher rates (good) and pay tax later at lower rates (also good).
Higher earners will likely be prevented from taking any tax deduction for traditional IRA contributions; for these individuals, the benefit from contributing to a traditional IRA is significantly limited.
Roth IRAs, by contrast, work in the reverse. With a Roth IRA, you’ll contribute after-tax money, and have the chance to invest it entirely tax-free for the rest of your life.
In this scenario, you implicitly volunteer to pay tax at today’s rates (based on the income you’re earning today) in exchange for a zero tax liability on the money forever – as long as you meet the holding period requirements.
Roth IRAs tend to work better for those who expect their tax rate in retirement to be higher than their tax rate while working, and it also benefits those who don’t want any tax risk going forward. It’s also a good choice when rolling over your 401(k), particularly if you’re rolling over a Roth 401(k). There is a definite possibility – and a more short-term certainty – that tax rates will rise in the future, so volunteering to pay tax today at presumably low rates can make a lot of sense.
The biggest disadvantage to Roth IRAs is not in the tax realm, but instead in the direct contribution restrictions. Roth IRAs come with strict income limits, meaning you can’t contribute directly to a Roth IRA if you and/or your spouse earn over a certain amount.
As mentioned earlier, there are no limits on how much you can roll over into Roth accounts, but there are limits on how much you can directly contribute. Direct contributions typically come from your checking or savings account and count towards your annual limits. Rollovers, conversely, can take place regardless of account size.
Roth IRAs also offer a significant psychological benefit; unlike pre-tax 401(k) money, every dime in your Roth IRA is entirely yours. Your 401(k) has an unseen tax liability that can fluctuate dramatically based on your overall income as well as Federal tax law. Be sure to give this some thought before you decide on contributions for the year!
|Traditional IRA||Roth IRA|
|Tax Deductibility||Potentially tax-deductible if you fall below certain income limits.||Not tax-deductible.|
|Withdrawals||Fully taxable at ordinary income tax rates if you received a tax deduction upon contribution.||Can withdraw tax-free and penalty-free if over age 59.5 and have held the account open for at least 5 years.|
|Contribution Limits||$6,500 annually ($7,500 if age 50+)||$6,500 annually ($7,500 if age 50+)|
|Income Limits||Must have earned income to contribute; no maximum income limit.||Cannot contribute directly unless you earn less than a certain amount.|
|RMDs||Required Minimum Distributions start by April 15th of the year you turn 72.||Not required unless the account is inherited.|