10 Must Knows with Traditional IRA’s and Roth IRA’s

by | Sep 10, 2020 | Financial Planning, Retirement

I think of myself as a mechanic. There are a variety of account types that people can invest with. Just like there is a variety of cars you can drive. You can yell as loud as you want about how some accounts are less valuable than others, or how you know the best retirement product. But regardless of how loudly you hate, some account types are still being used and need to be managed.

Ok, let’s say you love Tesla. You love their cars, and you think they are the way of the future. Maybe you are right. However, there are many car companies out there that people are still buying, selling, and using that get people to their destination. Regardless of how you feel about Tesla, those vehicles still need to be managed, repaired, adjusted, and maintained.

That is the same with account types. There is a variety of them out there, and we need to make good decisions surrounding how to manage that vehicle and what works best for your goals. Maybe that decision is to sell and get another car that will fit your needs better, who knows. But you need to evaluate everything and make quality, UNBIASED decisions.

Today we compare two “car companies,” the Traditional IRA and Roth IRA. Here is the IRS page for more information, and you can check my work.

10 Elements.

For comparison, I will break each element down into the Traditional IRA and Roth IRA, respectively. Although similar in some cases, there are a lot of differences. I will break down the differences then briefly summarize what to pay attention too.

***NOTE: The term “Trad” means traditional IRA and “Roth” means Roth IRA.***

1.Qualifications to Make Contributions

Traditional IRA

An Individual or Spouse must have earned income, no age restriction. (Under age 70.5 has since been changed. There was an age restriction where you could not contribute to Trad’s after age 70.5; this is no longer true. See section 107 of the Secure Act).

Roth IRA

An Individual or Spouse must have earned income, BUT there is not an age restriction.

In general, it is safe to assume that you need to have some sort of compensation to contribute to these accounts. You can already see a difference between the account types and the contribution age. We will discuss this later, but the Trad has required distributions that start at 72.

2.Contribution Limits

Traditional IRA

The maximum contribution is $6000 in a given year, and then if you are age 50 or older, you can put in an extra $1000 as a “catch-up” contribution.

Roth IRA

The maximum contribution is $6000 in a given year, and then if you are age 50 or older, you can put in an extra $1000 as a “catch-up” contribution.

The contributions limits are the same. This is going to be consistent with each account type.  However, the $6000($7000 if 50 or older) is the TOTAL amount you can contribute to either of the IRA types. You don’t get $6000 per account type. It is $6000 in total! You put in more, you are penalized. More on that later. 

This is not related to CONVERSIONS. Specifically, converting money that is in the ROTH to the Trad. There is not a limit on that move. I am just speaking about CONTRIBUTIONS.

3. Income Limitations

Traditional IRA

If you, or you and your spouse, are not covered by an employer-sponsored plan, you will always get a full deduction on the Trad contributions.

But, if you become covered by an employer-sponsored plan, that is when the phase-outs below apply. If you are covered by a plan, and your AGI is more than the high end of these ranges, you can not make DEDUCTIBLE contributions to a Trad.

Married Filing Joint, Qualified Widower $103,000-$123,000

Single, Head of Household $ 64,000-$74,000

Married Filing Separately $ 0-$10,000

Roth IRA

With Roth contributions, you never get a deduction when you contribute. The money that is contributed is after-tax dollars. Being involved with an employer-sponsored plan doesn’t matter with Roth’s because you don’t get a deduction.

However, there still are AGI ranges. If you make more than the high end of these ranges, you can not contribute to a Roth.

Married Filing Joint, Qualified Widower $193,000-$203,000

Single, Head of Household $122,000-$137,000

Married Filing Separately $ 0-$10,000

Now we are starting to see some significant differences between the two account types. The principal value of the Trad is the tax deduction when you contribute. You need to pay attention to when and how you can contribute to receive the tax deduction. The Roth never has a tax deduction, but the money is tax-free when it comes out. Will discuss later.

***The range is a “phase-out.” This means that if your AGI is within the range, the $6000 max is decreased. If you are above the range, you are phased out of making any contributions.**

4. Contribution Deadlines

The contribution deadline is the same for a Traditional IRA or Roth IRA. You have until the tax filing deadline for the year of contribution.

Example: You have until April 15, 2021, to make a 2020 contribution to either account. 

This can help a person file their taxes and find out what their AGI will be. Clients can have some freedom to make sure that they are within limitations to avoid reversibly taking money out. Getting the money back out can be a headache.

5. Allowable deductions

Traditional IRA

There is a full deduction from your gross income of the amount of Trad contributions if you, and spouse if married, are not covered by an employer-sponsored plan. If you are covered, refer to the income limitations above.

Another wrinkle, if you are not covered, but your spouse is, phase-out, is:

Married Filing Joint, Qual. Widower: $193,000-$203,000

Married Filing Separately: $ 0-$ 10,000

Roth IRA

Never a deduction from your gross income when you make a contribution to a Roth. Employer plan eligibility does not matter here.

The deduction for the Trad is the kicker. It is what makes people think it is a great option.

However, that money will be fully taxable when it comes out. Whereas the Roth, since there is not a deduction when the money goes in, it is tax-free when it comes out! This is where it is essential to know what the client wants and what the client’s particular situation is. There may be some benefit to the current Trad deduction that is more favorable to the tax-free future. See below.

6. Taxation of Distributions

Traditional IRA

Distributions are taxable as ordinary income. If you have a basis* in your IRA, there will be a pro-rata calculation to find the non-taxable portion.

Roth IRA

Qualified distributions are tax-free. If a non-qualified distribution, the earnings will be taxable. Contributions, since you never received tax deduction, are always tax-free.

This is the most significant difference between the two accounts—the ability to take money out tax-free. To be clear, this is assuming that you make “qualified distributions,” which we will discuss soon.

Another capability of a Trad, if you are outside of those income limitations that we mentioned above, is you can make “non-deductible” contributions. This means that you can put money in a Trad, but you will not get the tax deduction. The point of this is to get tax-deferred growth while the money is invested inside the account. There will be a basis if you do this, and the non-deductible contributions will not be taxed. A pro-rata calculation will help you determine what to pay taxes on. Consult a CPA is the short of that.

***Trad basis is money that was contributed WITHOUT A DEDUCTION. You can make non-deductible contributions to a trad. If this is done, that money is always tax-free, but the earnings on that money are taxable. Basis needs to be monitored for the future tax liability.***

7. Penalties

Both of these accounts have two penalties.

The more popular is the 10% early withdrawal penalty. This penalty will apply unless you meet an exception; see next. If you pull money out of the Trad, the IRS will assess a 10% penalty of the total amounts.

A Roth penalty will only start to apply when your investments accumulate earnings. Remember, contributions to a Roth are always tax-free, AND they come out first. So you would need to pull out more than your contributions to start to become penalized.

Example: you have contributed $20,000 to your Roth, but it is worth $30,000. If you pull out $30,000, only the $10,000 will be penalized and taxed if you don’t meet one of the exceptions below. The $20,000 is after-tax contributions.

The other penalty is the 6% excess contribution penalty. This applies to both accounts. If you contribute more than the $6000 ($7000 if 50 or older), you will be assessed a penalty of 6%.

8. 10% Early Withdrawal Penalty Exceptions

These exceptions help an IRA account owner avoid the 10% penalty on taxable distributions. Remember, taxable distributions mean different things for a Trad and a Roth. But do note, if you take money out of an IRA and you meet one of these criteria, you avoid a penalty.

A distribution is penalty-free if it is:

  1. On or after age 59.5

  2. After becoming disabled

  3. To a beneficiary of a deceased owner

  4. Substantially equal periodic payments.

  5. To the extent of unreimbursed medical expenses exceeding 10% of AGI

  6. Made to unemployed individuals to pay for health insurance premiums

  7. To an extent taxpayer has qualified higher education expenses.

  8. Used to buy, build, or rebuild first home (up to $10,000 lifetime limit).

  9. For IRS levies on account

  10. Made to certain military personnel.

  11. Distribution made within 1-year of birth or adoption(IRS Notice 2020-68)

These guidelines are more common with Trad’s than they are with the Roth. The biggest one is the 59.5 number. If you wait until 59.5, you can withdraw money without a penalty. Remember, most likely, Trads are fully taxable. These exceptions are for avoiding the added penalty ONLY. A Roth, if you wait until 59.5, all money is tax-free.

Roth has one more rule called the 5-year rule. If you want a Roth distribution to be fully qualified, you must have had the account open for 5 years and meed the other requirements above.

9. Required Minimum Distributions

Traditional IRA

RMD Start dates

  • April 1 of the year following the calendar year in which you reach age 70½, if you were born before July 1, 1949.

  • April 1 of the year following the calendar year in which you reach age 72, if you were born after June 30, 1949.

Roth IRA

None while living. RMD’s do not apply until you pass away.

Still finding differences. RMD’s are a big-ticket item for the IRS on Trad’s. The IRS wants their money and they are saying that you have to start taking money out and paying taxes on it at age 72.

This is a huge planning opportunity while in retirement. You can’t just leave the money in Traditional IRAs and rack up that tax deferral until you pass away. You have to start taking money out, which could negatively affect your taxes and income in retirement.

10. Rollovers and Conversions

Traditional IRA

Funds may be rolled into another IRA or employer retirement plan without a taxable event.

Roth IRA

Funds from one Roth can be rolled into another Roth tax-free. Or, can be converted into a Trad.

There are also Roth Conversions where you can roll funds from the Trad to the Roth. This is subject to income tax but not a penalty. This helps to reposition assets from future taxation to the future tax-free.

I’m Full

Why does the IRS make it so complicated? So many rules and guidelines that we have to follow when monitoring these accounts. This is why I like to view myself as a mechanic. I have to take the car that comes into the shop and fix it. As long as there are different varieties of vehicles on the road, I will be here to help. As long as Traditional and Roth IRA’s exist, I will be here to help manage them.

However, along the way, I like to find a vehicle that fits you a little better. Maybe I can help manage your existing vehicle, and we can transition to a better vehicle that fits your needs.

That is called ADDING VALUE!

Want to go deeper?

Check out our library of free financial resources on ProPath Financial.

About the Author

Thatcher Taylor is a Certified Financial Planner™, MBA, and owner of ProPath Financial. Thatcher’s three most important things to him are family, financial planning, and fitness. He has been an advisor for over 10 years and now specializes in comprehensive financial planning and asset management. Thatcher writing has previously been featured in Forbes. 

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