IRAs are not limited like an employer-sponsored retirement plan. You are free to choose most types of investments in order to reduce fees or better diversify.
Opening an IRA is straightforward; in fact, it takes just a few clicks at Betterment. What you really need to consider is which type of IRA—Roth or traditional—is right for you.
Your first task is to determine which IRA fits your personal or household income.
- Roth IRA: Your ability to contribute to a Roth IRA diminishes as your income rises. If you are married filing jointly, your ability to contribute starts phasing out at a modified gross adjusted income (MAGI) of $183,000 for 2015, and $184,000 for 2016.
If you are single, the phaseout begins at $116,000 for 2015, and $117,000 for 2016.
- Traditional IRA: Once your MAGI hits $193,000 (married) or $131,000 (single), you can’t contribute to a Roth IRA. Instead, you’ll want to contribute to a traditional IRA, but tax deductibility is dependent on other factors outlined below.
If you still want to invest into a Roth IRA, you need to make contributions to a traditional IRA, and then convert it into a Roth, but taxes may be due.
Consider the Tax Benefits
After you have determined the type of IRA for which you’re eligible, you’ll then need to decide which is best for your personal tax situation:
- Roth IRA: No tax deduction for your contribution; you contribute to the account with after-tax dollars. However, the money grows tax-free, so when it’s time to withdraw the money, you don’t have to pay taxes on it.
- Traditional IRA: Receive a tax deduction now (reducing your current income for tax purposes), for the contributions you make. Your money grows tax-deferred, meaning you don’t have pay taxes until you begin withdrawing money from your account later, when the money is taxed at your marginal rate.
The main question to ask is whether you expect to be in a higher tax bracket than you are now when you withdraw from the account in retirement. If you choose a Roth IRA, you pay taxes now, but if you retire in a higher tax bracket, or if tax rates go up over time, you are protected from those increases.
With a traditional IRA, you save money now—providing you can claim tax deductions. If you are concerned about your current cash flow, and you want to reduce your tax liability right now, a traditional IRA can work for you. A traditional IRA is also ideal if you think that your taxes will be lower later. You’ll put off paying your taxes until you are likely to owe less.
Your ability to offset your current tax liability with your traditional IRA contributions can be limited by your income. Once you reach certain thresholds (which are set based on whether or not you (or your spouse) have access to a retirement plan through an employer), your deduction starts to phase out. See the IRS site for deduction limits.
Betterment is not a tax advisor and cannot provide tax advice. This information is for educational purposes only. You should consult a tax professional regarding your personal situation.
Which IRA should you use?
Use the calculator to get customized IRA advice.
If you can’t contribute to a Roth IRA due to income restrictions, but you are concerned about taxes in the future, you can convert from a traditional to Roth IRA, and pay taxes now.
Generally, if you feel that your taxes will be higher in the future, a Roth is considered a good choice.
This post has been updated with current IRS information.