Saving and investing for retirement is best done from multiple angles, using all the resources available to you. One resource everyone should take advantage of is an IRA. There are two types of IRAs: Roth and traditional. Unlike a 401(k), an IRA isn’t tied to your employer and must be opened on your own, like a regular bank account.
The main difference between Roth and traditional IRAs — and what should ultimately decide which one you contribute to — is when you get your tax break.
With both Roth and traditional IRAs, you can contribute after-tax money, but there’s a chance you can deduct your traditional IRA contributions, depending on your filing status, income, and whether or not you have a retirement plan at work. Since you get your tax break upfront with a traditional IRA, you’ll owe taxes on the withdrawals in retirement, which you must begin taking at age 72 because of the required minimum distributions (RMDs).
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With a Roth IRA, you can’t deduct your contributions, but you can take tax-free withdrawals in retirement. If your current tax bracket is likely going to be lower than your tax bracket in retirement, it makes sense to go with a Roth IRA and pay taxes now while your rate is less.
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You might one day be ineligible for a Roth IRA
Unfortunately, one downside to Roth IRAs is their income limit. Here’s how much you can contribute to a Roth IRA:
| Filing Status | Annual Income | Amount You Can Contribute (50 or older) |
|---|---|---|
| Married filing jointly |
Less than $204,000 |
$6,000 (or $7,000) |
| Married filing jointly |
$204,000 to $213,999 |
Reduced amount |
| Married filing jointly |
$214,000 or more |
$0 |
| Married filing separately |
Less than $10,000 |
Reduced amount |
| Married filing separately |
$10,000 or more |
$0 |
| Single |
Less than $129,000 |
$6,000 (or $7,000) |
| Single |
$129,000 to $143,999 |
Reduced amount |
| Single |
$144,000 or more |
$0 |
As you’re advancing through your career, there’s a chance that you’ll one day find yourself above the income limit and ineligible to contribute to a Roth IRA. Before that happens, you should take advantage of the tax benefit that comes with Roth IRAs. Having the opportunity for your money to grow and compound with tax-free withdrawals in retirement can easily save you thousands of dollars in taxes down the road.
The maximum amount you can contribute to a Roth IRA for tax year 2022 is $6,000 ($7,000 if you’re 50 or older).
If you were to contribute $6,000 yearly ($500 monthly) for 20 years, averaging 10% annual returns, your account would be over $343,500. If it were in a non-Roth IRA account, you would owe taxes on close to $223,000 in capital gains. However, since it’s held in a Roth IRA, the full $343,500 would be tax-free to withdraw in retirement.
What to do after passing the limit
If you’re over the income limit for eligibility, you can still contribute to a Roth IRA, you’ll just have to take a different route. This is known as a backdoor Roth IRA. To create one, you’ll need to first contribute to a traditional IRA (which doesn’t have an income limit), then convert the traditional IRA to a Roth IRA. The process might vary by plan provider, but you can usually do it online or by reaching out to the provider and having it do the conversion for you.
When you make a conversion, any money you convert that was previously deducted from your taxes will generate taxable income. For example, if you contribute $5,000 to a traditional IRA, deduct $3,000, and then convert the full $5,000 into a backdoor Roth IRA, $3,000 would become taxable income.
If you were able to deduct your full traditional IRA contributions and then convert them to a backdoor Roth IRA, then the resulting taxable income cancels out the deduction, leaving you with no tax impact.
If you’re eligible to contribute to a Roth IRA, you don’t have to go through the hassle of the backdoor Roth IRA route, but if you’re ineligible, the conversion process can very well be worth it. There are few gifts from Uncle Sam as impactful as being able to have your money grow and compound with tax-free withdrawals in retirement.
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