Are you saving for the future? Individual retirement accounts are a common way to put money aside for your retirement years. However, do you understand the difference between traditional and Roth IRAs and how these accounts can affect your taxes? Let’s break down how IRAs function and how they can help set you up for a brighter tomorrow.
How much can you contribute to a traditional or Roth IRA per year?
There are two major types of IRAs: traditional IRAs and Roth IRAs. Both allow you to make annual combined contributions of up to $7,000 in 2024. Generally, you must have at least as much taxable compensation as the amount of your IRA contribution. However, if you are married and filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers aged 50 and older to make additional “catch-up” contributions. These individuals can put up to an additional $1,000 into their IRAs in 2024.
Traditional and Roth IRAs both feature tax-sheltered growth of earnings and both typically offer a wide range of investment choices. However, there are important differences between these two types of accounts. You must understand these differences before you can choose the type of IRA that may be appropriate for your needs.
What tax advantages come with contributing to an IRA?
Practically anyone can open and contribute to a traditional IRA. The only requirement is you must have taxable compensation. You can contribute the maximum allowed each year if your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount you earned.
Your contributions to a traditional IRA may be tax-deductible on your federal income tax return. This is important because tax-deductible (pre-tax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or another employer-sponsored plan, you can generally deduct the full amount of your annual IRA contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income or MAGI) and your income tax filing status. You may qualify for a full deduction, a partial deduction, or no deduction.
Traditional IRAs — Tax Year 2023 (Individuals Covered by an Employer-Sponsored Plan):
| Filing Status | Deduction is limited if MAGI is between: | No deduction if MAGI is more than: |
| Single/head of household | $73,000 – $83,000 | $83,000 |
| Married filing jointly* | $116,000 – $136,000 | $136,000 |
* If you’re not covered by an employer-sponsored plan but your spouse is, your deduction is limited if your MAGI is $204,000-214,000 and eliminated if your MAGI exceeds $214,000.
Source: IRS.gov
What happens when you start withdrawing money from your traditional IRA?
Any portion of a distribution that represents deductible contributions is subject to income tax since those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax since those earnings were also not previously taxed. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10% early-withdrawal penalty if you’re under the age of 59 ½ unless you meet one of the exceptions. For details on these exceptions, visit the IRS website.
Not everyone can set up a Roth IRA. If you can, you may not qualify to take full advantage of it. The first requirement is you must have taxable compensation. If your taxable compensation is at least $6,000 in 2022, you may be able to contribute the full amount. However, it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status. Your allowable contribution may be less than the maximum possible or zero.
Roth IRAs — Tax Year 2023:
| Filing status | Contribution is limited if MAGI is between: | No contribution if MAGI is more than: |
| Single/head of household | $138,000 – $153,000 | $153,000 |
| Married filing jointly | $218,000 – $228,000 | $228,000 |
Your contributions to a Roth IRA are not tax-deductible. You can only invest after-tax dollars in a Roth IRA. However, if you meet certain conditions, your withdrawals from a Roth IRA will be completely free of federal income tax, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:
- You have reached age 59 ½ by the time of the withdrawal.
- The withdrawal is made because of disability.
- The withdrawal is made to pay first-time homebuyer expenses ($10,000 lifetime limit from all IRAs).
- The withdrawal is made by your beneficiary or estate after your death.
Qualified distributions will also avoid the 10% early withdrawal penalty. The ability to withdraw your funds with no taxes or penalty is a key benefit of the Roth IRA. And remember, even nonqualified distributions will be taxed — and possibly penalized — only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions you have made.
Another advantage of the Roth IRA is there are no required distributions after age 72 or at any time during your life. You can delay taking distributions until you need the income, or you can leave the entire balance to your beneficiary without ever taking a single distribution.
What should someone with an IRA know before filing their taxes? You can still make a 2023 contribution up until the federal tax filing deadline on April 15th.
Anything else people should know? Assuming you qualify to use both, choosing between a traditional IRA and a Roth IRA can be confusing. The Roth IRA might be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA or if you want to help reduce taxes during retirement and preserve assets for your beneficiaries. However, a traditional IRA may be a better tool if you want to lower your annual tax bill while you’re still employed and possibly in a higher tax bracket than you’ll be in during retirement.
Working with a financial advisor can help you navigate this, along with other important financial and investment decisions. Our First Mid Wealth Management financial advisors are here to help! Contact us at 800-546-5721 or 217-258-3344 or see our team of financial advisors online here.
Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax issues.
Please consult with your tax advisor for advice concerning your individual circumstances.
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