Unlike employer-sponsored retirement plans, which typically have limitations on investment options and fees, IRAs often have more flexibility, with a broader range of investments. More options can help you reduce fees or better diversify.
The challenge for most people is understanding which kind of IRA is most advantageous for them—Roth, traditional, or some combination of both. The advantages of each can shift over time as tax laws and your income level change, so this is a common periodic question for even advanced investors.
Major Factor in Choosing Your IRA: Household Income
As a baseline, you must earn income in a given year to be eligible to contribute to an IRA. For 2017 and 2018, the maximum contribution that an individual can make to IRAs is the lesser of $5,500 ($6,500 if age 50+), OR earned income. In other words, if your earned income was only $3,000, then your maximum allowable contribution is $3,000.
Additionally, your income will determine whether you are able to contribute to a Roth IRA, and also whether you are eligible to deduct contributions made to a traditional IRA. However, the IRS doesn’t use your gross income; they look at your modified adjusted gross income, which can be different from taxable income. With Roth IRAs, your ability to contribute is phased out when your modified adjusted gross income (MAGI) reaches a certain level:
- For married taxpayers who file jointly, the phaseout for 2017 contributions begins at $186,000, and you are completely phased out when your MAGI reaches $196,000. For 2018 contributions, the phaseout begins at $189,000, and you are completely phased out completely when your MAGI reaches $199,000.
- If you are single, the phaseout for 2017 contributions begins at $118,000, and you are completely phased out when your MAGI reaches $133,000. For 2018 contributions, the phaseout begins at $120,000, and you are completely phased out when your MAGI reaches $135,000.
For more information, see the IRS overview of IRA contribution limits.
Regardless of how high your income may be, you can always contribute to a traditional IRA. But your modified adjusted gross income—along with whether or not you are covered by an employer-sponsored retirement plan—will determine whether or not you are eligible to deduct your traditional IRA contribution.
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. 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. Check out this IRS resource on IRA deduction limits.
If you can’t contribute to a Roth IRA due to income restrictions, but also are not able to deduct your traditional IRA contributions, you may consider a Roth conversion (otherwise known as a backdoor Roth contribution). Note that there may be tax consequences from making a Roth conversion, and whether this strategy is right for you depends on your situation.
Betterment is not a tax advisor, and we don’t provide tax advice as a service, so this information is just for educational purposes. You should consult a qualified tax professional regarding your personal situation.