An individual retirement account (IRA) can help self-employed individuals save for their retirement. While you're allowed to have an IRA in addition to a company 401k, it's especially popular for people who don't have access to an employer-sponsored retirement plan.
There are many types of IRAs, but the most common ones are the traditional IRA and Roth IRA. Both are similar types of accounts, but they have some key differences in tax treatments, eligibility, and withdrawals.
Annual contribution limits are the same for both the traditional IRA and Roth IRA.
The contribution limit for a traditional IRA and Roth IRA is $6,000 ($7,000 if age 50+) in 2022 and $6,500 ($7,500 if age 50+) in 2023.
Your contributions cannot exceed the amount of income you earned that year. For example, if you only earned $4,000 in 2022, you can only contribute up to $4,000 into a traditional or Roth IRA.
You have until the federal tax filing deadline to make contributions into your account. Typically, that's April 15, of the following year. For 2023, the exact federal tax-filing deadline is Tuesday April 18, 2023 since the 15th falls on a Saturday and the coming Monday is a national holiday.
The main difference between the two accounts is when they get taxed.
Put another way, a traditional IRA gives you tax savings now and a Roth IRA gives you tax savings in retirement.
For example, let's say you make $50,000 this year in income and decide to contribute $6,000 into an IRA this year.
Anyone with earned income can start making contributions to a traditional and Roth IRA even if they're not 18 years old. For example, a 10 year old child with a paper route is eligible to contribute to a traditional or Roth IRA.
For both the traditional IRA and Roth IRA, anyone with earned income can contribute to either account.
However, there are some additional eligibility rules with each account.
A Roth IRA has an income limit, while a traditional IRA has no income limit. If you make too high of an income, your contribution limit gets reduced or you're not allowed to contribute at all.
Here are the Roth IRA income limits for 2022 and 2023:
One workaround to the Roth IRA income limit is the mega backdoor Roth IRA. Essentially, you can make your contributions to a separate after-tax account, and then immediately rollover the funds into your Roth IRA. A rollover doesn't follow the same Roth IRA income limits or contribution limits.
With a Roth IRA, if your income is too high, you can't contribute. With a traditional IRA, it works a little bit differently. If you have a retirement plan at work, your tax deductions can get reduced if your modified adjusted gross income (MAGI) is too high.
Remember, this only applies if you also have a day job where you receive a company 401k.
You can calculate your modified adjusted gross income (MAGI) using Worksheet 1-1 in IRS Publication 590-A.
Withdrawal rules are different for the traditional IRA and Roth IRA.
When you can withdraw without penalties: You can start taking qualified distributions from your traditional IRA when you reach the age of 59½.
Taxes on withdrawals: With a traditional IRA, you contributed with pre-tax dollars and received a tax-deduction. Therefore, your withdrawals in retirement will be taxed as regular income.
Penalties for early withdrawals: Early withdrawals will be hit with a 10% fee plus income taxes on the amount withdrawn.
When you can withdraw without penalties: With a Roth IRA, you can withdraw your contributions at any time without penalties or fees. This is because you already paid taxes on your contributions.
If your account has any earnings, that portion of your account cannot be withdrawn until you reach the age of 59½ AND you made your first Roth IRA contribution at least 5 years ago. This is called the Five-Year Rule, and it applies only to the Roth IRA and not the traditional IRA. For example, if you open your Roth IRA and make your first contribution when you're 57 years old, you will have to wait until you're 62 in order to withdraw earnings from your Roth IRA without penalties.
Taxes on withdrawals: With a Roth IRA, you don't pay any taxes when you take qualified distributions, since you already paid taxes when you made your contributions.
Penalties for early withdrawals: Withdrawals of contributions have no penalties regardless of your age or account age. Early withdrawals on account earnings will be hit with a 10% fee plus income taxes.
RMD stands for required minimum distribution. Most retirement plans have RMD rules set by the IRS, which state that participants of a plan must start taking distributions each year once they reach the age of 72.
A traditional IRA has required minimum distributions, while a Roth IRA does not. With both accounts, you're allowed to continue making contributions past the age of 72. However, you must start taking withdrawals from a traditional IRA, whereas you can leave your Roth IRA alone as long as you're alive.
You can view how to calculate your RMD amounts using this RMD table.
Yes, you can have both a traditional IRA and a Roth IRA and contribute to both in the same year. However, your total contributions to both accounts must not be greater than the yearly contribution limit.
For example, let's say you wanted to contribute half your money into a traditional IRA and the other half into a Roth IRA. In 2022, the contribution limit for a traditional and Roth IRA is $6,000 or $7,000 if you're 50 or older. If you're under 50 years old, you could contribute a maximum of $3,000 into a traditional IRA and another $3,000 into a Roth IRA.
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