Holiday traditions often include giving gifts to friends and family. Why not give yourself a gift for the future this year by investing in a new or existing Individual Retirement Account (IRA)? It can also be a gift when tax time rolls around next April, depending on the IRA you choose.
IRAs for the Future
IRAs are considered a quintessential way to save for retirement. For those who don’t have a retirement plan through their employer, it may be a good alternative. Or it can be a supplement for those who do.
IRAs also offer tax-advantages—some later and some now—depending on whether you choose a Traditional or Roth. Both offer a tax advantaged way for your money to grow. And there are no age limits for who can contribute, but you must have earned income.
For 2020, you can add up to $6,000 into a Traditional IRA, or into a Roth IRA, if you qualify. If over age 50, the IRS limits you to $7,000. From there, the two have differences.
Roth IRAs Offer Tax-Free Withdrawals
With a Roth IRA, you contribute money that has already been taxed, which is why you cannot deduct it later at tax time. You can withdraw your contributions any time without penalties because you have already paid taxes on them.
Earnings can be withdrawn without taxes or penalties after age 59½ and if you’ve had the account for five years. Before that, you will pay an early withdrawal penalty of 10%. A reason to choose a Roth IRA is if you think taxes will be higher in retirement. You are also not required to take a minimum distribution from a Roth.
Traditional IRAs Offer Tax Deductible Contributions
With a Traditional IRA you may be able to deduct the amount you contribute from your income tax. It depends on how much income you make. Earnings can grow tax-deferred, meaning you won’t pay taxes on them until you withdraw them at retirement. Withdrawals are taxed as ordinary income and there are no penalties if they are taken after age 59½.
One reason to choose a Traditional IRA is if you believe your taxes today are higher than what they will be in retirement. When you turn age 72 (or 70½ if you were born before July 1, 1949) the IRS requires you to take a distribution every year. You will also need to pay taxes on it. Note that the SECURE Act eliminated the minimum distribution requirement for 2020.
More Details About Roth vs. Traditional IRAs
Compare the features of both IRAs to determine which one might be the best for your situation. There are also income requirements and information about deductions that you should be aware of.
You must have earned income below the annual limits.
You may be partially eligible if your income is within the annual phase-out range.
You must have earned income.
Contributions are not tax deductible. They can be withdrawn tax-free and penalty-free at any time.¹
TAXABILITY OF CONTRIBUTIONS AND EARNINGS
Some or all contributions may be tax deductible.²
Income tax on earnings deferred until you withdraw them.³
At age 59½, you can make penalty-free withdrawals.
You are not required to take money out at any age. Plus, you can contribute as long as you have earned income.
At age 59½, you can make penalty-free withdrawals.
In the year you turn age 72, you must take minimum distributions annually to avoid a 50% penalty on the amount you're required to withdraw.
What About a Roth Conversion?
Some people choose to convert their Traditional IRA into a Roth IRA, thus changing how the account is classified. In doing so, they will pay taxes now, rather than later. You can convert all or part of your Traditional IRA to a Roth IRA without being subject to the 10% early withdrawal penalty. You will owe taxes in the year you convert on any contributions and earnings not previously taxed.
State and local taxes may apply.
Some or all contributions may be tax deductible, depending on your modified adjusted gross income, tax-filing status and if you or your spouse participated in a workplace plan.
IRA investment earnings are not taxed. Depending on the type of IRA and certain other factors, these earnings, as well as the original contributions, may be taxed at your ordinary income tax rate upon withdrawal. A 10% penalty may be imposed for early withdrawal before age 59½.
Please consult your tax advisor for more detailed information regarding the Roth IRA or for advice regarding your individual situation.
Taxes are deferred until withdrawal if the requirements are met. A 10% penalty may be imposed for withdrawal prior to reaching age 59½.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.