By Jo Madonna, E.A. | September 13, 2019

The Role of Traditional and Roth IRA Taxation

Ask anyone who is putting money aside for retirement what the first thing was that they invested in, and they’ll probably say, “An IRA.” It is, in fact, one of the easiest ways to save for retirement. It lets IRA owners make ongoing contributions and invest them in a portfolio of stocks, bonds, mutual funds or other instruments. Easy or not, the IRA taxation deserves a closer look.

Congress created the IRA (Individual Retirement Account) in 1974 for two purposes:

  • To provide individuals not covered by a retirement plan at work with a tax-advantaged savings plan; and
  • To act as a supportive piece to employer-sponsored retirement accounts that needed to be rolled over when individuals experienced a job change or moved into retirement.

In 1997, Congress added the Roth IRA, which offered a very different set of retirement opportunities.

Since their creation, IRAs have been a fast-growing component of the U.S. retirement market. The two most popular accounts are:

  • Traditional IRA
  • Roth IRA

For both traditional and Roth IRAs, contribution limits may change from year to year to reflect increases in the cost of living. Changes are usually made in $500 increments. In 2019, IRA contribution limits for both are:

  • Under age 50: $6,000
  • Age 50 or older: $7,000 (considered a catch-up contribution)

The tax implications of each type of IRA will determine which will offer an individual taxpayer the most significant advantage. If and when your funds and earnings get taxed may affect which you choose, and your decision could depend on whether you think your tax bracket will be higher now or later in life.

Traditional IRA Taxation

A taxpayer may contribute to a traditional IRA up to the dollar value listed above and may take a deduction, or above-the-line adjustment, when filing taxes. However, the ability to contribute may be reduced or eliminated if the taxpayer – or spouse – has a retirement plan at his or her workplace. If neither is covered at work by a plan, then the deductions are allowed. Keep in mind, though, that the deduction could be limited or phased out depending on income levels as well.

While contributing to a traditional IRA allows taxpayers to lower their tax burden a bit, it is not without tax consequences. The IRS will want to collect the taxes on the income at some point. Payment will occur when the funds (and earnings) are withdrawn from the IRA. The tax rate will depend on the taxpayer’s income level that year.

Some rules are associated with traditional IRAs:

  • You can only contribute to a traditional IRA up to age 70½.
  • You will pay a penalty of 10% above the taxes due if you withdraw funds from a traditional IRA before you turn 59½.
  • Starting at age 70½, the IRS will require you to take “required minimum distributions,” or RMDs, to finally capture its taxes.
  • The beneficiary of an IRA will eventually have to pay the taxes on the proceeds of the IRA, but depending on beneficiary status, could enjoy some flexibility in the timing of payments. 

Roth IRA Taxation

The second type of IRA, called the Roth IRA, offers some unique tax advantages. However, an immediate tax deduction is not one of them, since they cannot deduct the contribution from their taxable income. Many of the advantages stem from the fact that the taxpayer is contributing to a Roth IRA with ‘after-tax’ dollars.

Roth IRAs have contribution phase-out rules based on income thresholds. In the case of married couples filing jointly, the phase-out range in 2019 is $103,000 to $123,000 if the spouse making the IRA contribution has a retirement plan at work. The deduction is phased out if the couple’s income is between $193,000 and $203,000 when the IRA contributor has no retirement plan at work but is married to a covered individual.

The Tax Cuts and Jobs Act of 2017 has made contributions to a Roth IRA more appealing. That act lowered the tax brackets and expanded them, so those taxpayers who are eligible to contribute can take advantage of the lower tax brackets while they last. (The ‘TCJA’ is set to sunset in 2025.)

The rules associated with Roth IRAs are:

  • You can contribute to a Roth IRA regardless of your age. However, your contributions must come from earned income.
  • The earnings generated in a Roth IRA can be held ‘tax-deferred’ within the account.
  • Taxpayers are never required to take distributions, so they can continue enjoying the tax-deferred growth of assets within the account.
  • Taxpayers can take tax-free withdrawals of both contributions and earnings after age 59½.
  • Beneficiaries may inherit a Roth IRA tax-free, so a Roth IRA provides a way to leave money to heirs free of taxes.

The Impact on Retirement Planning

Your IRA investment strategy can play a vital role in providing essential retirement income. Yet, many people contribute without thinking about IRA taxation and how to put those dollars to work to greatest effect. We would welcome the opportunity to create or review your tax strategy.