Outside of the 401k, there are two other tax-advantaged investment opportunities for retirement you’ve probably heard of. The Individual Retirement Account (IRA) and Roth IRA. Both have unique advantages and rules associated with them. which are important to be aware of.
Standard IRA vs Roth IRA: What’s the difference
When are you taxed!? The main difference between a Roth IRA and a traditional IRA comes down to the type of tax advantage you’re looking for.
With a traditional IRA, the goal is to get a tax deduction for the money you contribute now, but you'll pay taxes later when you withdraw it in retirement. In theory, for much of your life, you’ll be in a higher tax bracket than you will be when you retire. Meaning it’s advantageous to offset your tax burden now and pay a lower tax in retirement.
The Roth IRA flips this script: there is no upfront tax deduction, but your retirement withdrawals are tax-free. So you are investing money that you’ve already paid taxes on, and there is no deduction for putting money into a Roth IRA. That money grows and when you’re ready to use it, you’ll pay no taxes! In addition, in most cases, your Roth IRA does not have Required Minimum Distributions.
In 2024, the total IRA contribution limit is $7,000 for individuals under age 50 and $8,000 for those 50 and older. This is a combined total, so between your traditional and Roth IRAs, you can not exceed the limit.
Who Can Open a Roth IRA?
Sadly, not everyone can contribute directly to a Roth IRA. There are income limits, and if you're making too much dough, you might not qualify. For 2024, single filers need to have a modified adjusted gross income (MAGI) under $146,000 to contribute the full amount. If you make over $161,000 you’re ineligible to contribute—and there’s a sliding scale for salaries inbetween. For married folks filing jointly those limits are $230,000 to $240,000.
Make Too Much Money? Enter the Backdoor Roth IRA.
So, you want to contribute to a Roth IRA, but you exceed those income limits? Enter the "backdoor" Roth IRA. It's a legal workaround where you contribute to a traditional IRA (which doesn't have income limits for contributions, but does have income limits on deductibility) and then convert that money to a Roth IRA. This process involves paying taxes on any pre-tax dollars you convert, but it's a way to get into a Roth IRA and enjoy its tax-free benefits despite your income level.
A Roth IRA can be a powerful tool for retirement savings, offering tax-free growth and withdrawals. It's ideal for those who expect to be in a higher tax bracket in retirement and who qualify based on income.
We should note that if you make contributions to multiple IRAs across multiple institutions, the IRS lumps all of those contributions together and you may be violating the IRA Aggregation rule. This can complicate your conversion to a Roth—or make it more costly.
Every situation is unique, so if you’re considering an IRA or Roth IRA (front or back door), consult with a Certified Financial Planner. Perhaps one at Range.