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Retirement part 2: The depths of IRA account types

Retirement part 2: The depths of IRA account types

Wednesday, February 14, 2024 by Stephanie Guild, CFASteph is a Wall Street alum and head of investment strategy for Robinhood.
Nora Carol Photography/Getty Images
Nora Carol Photography/Getty Images

Like the famous line in Mean Girls, “the limit does not exist”, the depths of a practice does not have a floor. I was thinking about this while at a Japanese restaurant recently, talking to a server. They shared just how infinite the art of making Sake (rice wine) has become. From polishing grains of rice to experimenting with sushi rice in the process, there has been an exploration of every aspect. And this can be applied to every practice and sport – like at the Superbowl on Sunday—from both the players and Usher at halftime.

However, specialization can also be found in something less cultural (and maybe interesting?) — like the rules devised by the Internal Revenue Service (IRS) around taxes. They are a web of limitations, exceptions, and forms. It’s one of many reasons we have accountants and tax attorneys. Rules in saving for retirement can also be found at the IRS, so there are finer details to understand there, even if your taxes are as simple as possible. And they change annually, so it’s important to keep up (because saving for retirement is soooo important).

Having studied these for clients for decades, my part-two for “retirement season” (part one here) will focus on an aspect that is easy to misunderstand: the difference between Traditional IRAs and Roth IRAs.

  • Traditional IRAs are a type of retirement savings account where:

    • Contributions may be tax deductible

      • If you already put money into a 401k or other retirement plan, or your employer does for you, then a possible deduction on your income taxes for a contribution to this type of IRA is based on your income and how you file your taxes. The income limits vary each year—for example, for 2024, if you file your taxes as married, filing jointly, and make less than $143k, you may qualify for some deduction on your income taxes just for putting money away for future-you.

      • If you don’t put money in a workplace retirement plan, but still earn income, then you likely can contribute to a Traditional IRA and get a full deduction against your income, no matter how much you make. And this situation creates greater importance for saving for retirement.

    • Gains (and potentially contributions) are taxed when you withdraw your money, which typically happens in retirement.

    • Withdrawals before age 59½ are subject to penalties.

  • Roth IRAs are also a type of retirement savings account, where contributions are never tax-deductible. However:

    • Withdrawals of qualifying distributions are tax-free, which include a minimum holding period of five years, and you must be above the age of 59½.

    • There’s some more flexibility on withdrawals vs a Traditional IRA in that contributions (not gains or earnings) can usually be taken out without penalty at any time—though that should not be the goal of the account.

    • There are limitations on who can contribute directly to a Roth IRA based on income, which can vary each year. For example, for 2024, if you file your taxes as married, filing jointly, and make less than $230k, you may qualify for a full contribution to a Roth IRA.

Finally, let’s say you're fortunate enough to have income greater than the existing Roth IRA contribution income limits. In this case, something to know about as you consider retirement savings is a backdoor Roth. A backdoor Roth includes:

  • Setting up/having a Traditional IRA and a Roth IRA account, where contributions are first made to the Traditional IRA (with no deductions) and the contributed funds are then transferred to the Roth IRA account. This works best when the Traditional IRA is empty before contributing. 

  • Assuming the contribution is not invested, and transferred soon after, there should be no tax implications because there are no gains or earnings, and it gets you into a Roth IRA (through a backdoor). Check the IRS site for any required forms

  • Important Caveat: If you do this and have an existing Traditional IRA that was funded by rolling over a 401k or by contributions that you got a tax deduction from—meaning there are funds in it that were never taxed—then the backdoor Roth is more complicated. That’s because the transfer from the Traditional to the Roth would become taxed and would be based on how much of your total IRA funds were never taxed (irrespective of how much you are transferring in that year). This is called “the pro rata rule”. 

If you have a choice between the two, which type of account is right for you can depend on whether you want to save on taxes now (Traditional IRA) or not think about them in the future (Roth IRA). Some people, because so much is unknown about the future, and tax rates may have to go up to cover existing US federal deficits, prefer to get any extra funds into a Roth IRA.

This was a lot! As I said, specializations are everywhere, in every field. It’s impossible to know them all. But, just a few points can go a long way.

PS: This is a good resource for the details behind income and contribution limits for 2024.

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