Find the Right IRA in Three Easy Steps
Thinking through eligibility, tax rates now versus in the future.
This article was updated on March 14, 2018.
Investors spend a lot of time focusing on things they can't control. For instance, they worry about what direction the market is headed, but there's really no way to know and nothing anyone can do to influence its direction. It's more productive to instead focus on things you're truly in charge of, such as limiting your investment costs and making sure you're maximizing all of the tax-advantaged options that are available to you. That means contributing as much as you're able to your 401(k) and also funding an IRA if you're eligible.
You have until April 17, 2018, to make an IRA contribution for the 2017 tax year. If you have some extra cash on hand, why not fund an IRA for 2018, as well? Your money will compound on a tax-free or tax-deferred basis (more on the differences in a second). Unlike a 401(k) or other employee-benefit plan, in which you typically have a fixed menu of choices, your investment options for an IRA are virtually limitless. Also, while investing $5,500 per year (the IRA contribution limit for savers under age 50 in 2017 and 2018) might not sound like a lot, that money can grow to a fairly impressive sum over time. If, starting today, you contributed $5,500 annually to an IRA for the next 20 years and you earned 5% on that money, you'd have more than $180,000 at the end of the period.
Even if you're already convinced that saving in an IRA is sensible, you still have a little bit of research to do. There are two main types of IRA accounts, and selecting the one that's best for you can be a daunting process. Fortunately, you can figure this out in relatively short order by following these three steps.
Step 1: Know the Basics
If you're investing in an IRA, you'll quickly hit a fork in the road: Do you want a traditional or Roth IRA? Both vehicles let you sock away money and enjoy a tax benefit, but the rules are different.
With a traditional IRA, you may be able to take a tax break on your contribution, provided your income falls below the IRS' thresholds. You won't have to pay taxes on your traditional IRA's investment earnings until you begin taking distributions from it during retirement; thus, your money enjoys the benefit of tax-deferred compounding. (That means you'll have to pay taxes on your earnings and any deductible contributions when you begin withdrawing money from the kitty, but not as you go along.) With traditional IRA assets, you need to begin pulling your money out once you reach age 70-1/2.
In many ways, the rules governing Roth IRAs are the exact opposite of traditional IRAs. You can't deduct your contribution to a Roth IRA; you put in money that you've already paid taxes on. The big benefit of that setup is that qualified distributions from a Roth will be tax-free, not tax-deferred as is the case with a traditional IRA. Whereas traditional IRAs carry restrictions governing when you have to begin taking distributions, the Roth carries no such restrictions; you won't be forced to take distributions at any age. That's great news for savers who may not need to use their IRA assets in retirement; instead, they can let the money compound and grow for their heirs. Finally, Roth IRA investors can withdraw their contributions (not their investment earnings) at any time and for any reason. That flexibility is a big attraction for beginning investors who would like to save for retirement but are also investing for short-term goals, like a home down payment or a wedding.
Step 2: Determine Your Eligibility
Both traditional and Roth IRAs have their own attractions. Which is best?
Eligibility rules could make that decision for you. Let's start with income limits first. As I noted above, you can't make a deductible contribution to a traditional IRA if you (or your spouse, if you're part of a married couple filing jointly) are covered by a retirement plan at work and your income comes in above a certain level. In 2017, individuals who can contribute to a retirement plan at work and have modified adjusted gross incomes of more than $72,000 cannot deduct their IRA contributions; the 2017 modified adjusted gross income threshold is $119,000 if you're part of a married couple and can contribute to a retirement plan at work. Those thresholds are slightly higher for 2018 contributions: $73,000 for single filers and $121,000 for married couples filing jointly. (If you cannot contribute to a retirement plan at work but your spouse can, the modified adjusted income thresholds are higher still--$196,000 for 2017 contributions and $199,000 for 2018 contributions.) It's also worth pointing out that you can't make a traditional IRA contribution once you pass age 70-1/2.
The Roth IRA has more generous limits on contributions. You can continue to make Roth IRA contributions after age 70-1/2, provide you or your spouse have enough earned income (from work, not from Social Security, portfolio income, or pensions) to cover the contribution amount. The income thresholds are also higher: In 2017, single filers can make at least a partial Roth IRA contribution as long as their modified adjusted gross incomes fall below $133,000, whereas married couples filing jointly can make at least a partial Roth contribution as long as their modified adjusted gross incomes are less than $196,000. For 2018, those thresholds increase to $135,000 and $199,000, respectively.
Investors with very high incomes--i.e., those who cannot make a deductible traditional IRA or Roth IRA contribution--can still make an IRA contribution. Anyone, regardless of income, can contribute to a traditional IRA. High-income investors won't be able to deduct their contributions if their income is higher than the levels outlined above, but they'll be able to enjoy tax-deferred growth on their traditional IRA assets as long as the money stays inside the IRA wrapper. Better yet, they can immediately convert their contribution to a Roth IRA and enjoy tax-free withdrawals in retirement. This maneuver is called a "backdoor," or two-step, Roth IRA, and it allows high-income savers to get some assets into the Roth IRA column. However, it's not advisable for investors who have other traditional IRA assets--apart from the new IRA assets. For those shut out of a traditional deductible or Roth IRA contribution because they earn too much, it's important to check with a financial or tax advisor before undertaking a backdoor Roth IRA.
Step 3: Weigh Your Options
Income level, age, and whether you can contribute to a retirement plan at work may simplify your decision-making about whether to contribute to a Roth or traditional IRA.
But what if you establish that you're eligible to make more than one type of IRA contribution--you can contribute to a Roth AND make a deductible contribution to a traditional IRA? In that case, you'll need to think through when you'll most benefit from the tax breaks afforded by each IRA type.
If you think your income level--and in turn your tax rate--is apt to be higher now than it will be when you begin withdrawing the money in retirement, you're better off taking the tax break today, when you'll derive a greater benefit from it, than later on. If you can deduct your IRA contribution on your tax return, a traditional IRA contribution will make sense in that scenario; you take the deduction, at today's higher tax rates, because it will benefit you more right now than a tax-free withdrawal from a Roth will in retirement. A common profile of someone who will benefit from a traditional deductible IRA contribution is an older worker who hasn't yet amassed much in retirement savings; that individual's income level while working is apt to be higher than in retirement.
On the other hand, if you expect your income--and in turn your tax rate--to be higher in retirement than it is today, a Roth IRA contribution makes more sense. You'll put in aftertax dollars (effectively paying taxes on your contributions) but in exchange you'll pull the money out tax-free. This strategy makes sense for people whose income is at a fairly low level relative to what it's apt to be in the future--for example, an entry-level worker who expects his or her income to trend higher as the years go by. IRA conversions--from traditional to Roth--can also make sense when an individual's tax rate is at a low ebb relative to where it will be in the future.
The calculus is similar for investors who can make either traditional or Roth contributions to a company retirement plan. Of course, comparing today's tax rates with future tax rates is more art than science: Your own earnings trajectory is in the mix, as is the direction of tax rates on a secular level. If you're not sure about whether to make a traditional or Roth IRA contribution and are eligible to contribute to both, you can split your contribution across both account types.
A version of this article appeared Jan. 26, 2010.