First, What is an IRA?
An IRA (Individual Retirement Account) helps you save for retirement while you reap tax advantages along the way. We offer both Traditional and Roth IRAs. This post provides a general overview. Neither Veritas Federal Credit Union nor any of its employees are tax or legal advisors. We strongly suggest you consult your personal tax or legal advisor before making tax or legal-related investment decisions.
Which type is best for me?
You typically decide which one to contribute to based on whether you’d rather receive a tax break up front (Traditional Individual Retirement Account tax deduction) or later (tax-free Roth Individual Retirement Account distribution). Assuming you contribute the same amount to each type, what do you do with the money you save in taxes by making tax-deductible contributions to a Traditional IRA?
Would you save the annual tax savings each year and invest it for retirement? Or would you spend it?
If you wouldn’t invest the tax savings, a Roth IRA may provide more money after taxes at retirement. If you spend or don’t invest the tax savings, there is no money to add to your Traditional IRA. You may be giving up a tax break today when you make Roth IRA contributions, but you may have a larger retirement fund down the road.
What will your retirement income tax bracket be?
If you would invest the tax savings from a Traditional IRA, you might decide based on whether you think your tax bracket in retirement will increase, stay the same, fall slightly, or significantly decrease.
If you think your income tax bracket in retirement will significantly decrease, you’ll generally have more money after taxes at retirement if you contribute to a Traditional IRA. A Traditional IRA comes out ahead of the Roth IRA because you’re sheltering your current income from a higher tax rate now and making withdrawals later when you’re in a lower tax bracket.
But if retirement is still far off, you have the advantage of tax-free earnings with a Roth. More flexible withdrawal rules may outweigh the tax savings from deductible contributions today. If you think your retirement tax bracket will be the same or higher, you may have more money after taxes at retirement if you contribute to a Roth IRA.
Tax laws are complicated and do change periodically. If you need help figuring out your Modified Adjusted Gross Income (MAGI), or if you have any questions about IRA contribution and income limits, contact a trusted tax professional.
When can I withdraw funds?
You can withdraw money from your Individual Retirement Account at any time, but the IRS generally assesses a 10% early distribution penalty tax on the taxable portion of any withdrawals you make before turning age 59½. Congress created Traditional IRAs as a tax-favored way to save for retirement, so most distributions from a Traditional IRA will be taxed as ordinary income. You’ll owe taxes on your earnings and on any deductible contributions you made, in addition to this penalty tax.
The early distribution penalty tax
The early distribution penalty tax may not apply if your distribution is taken for any of the following reasons:
- Payments to beneficiaries after an IRA owner’s death
- Disability (permanently disabled under the IRS definition)
- First-time home purchase
- Unreimbursed medical expenses over a certain amount
- Health insurance premiums during unemployment
- Qualified higher education expenses
- IRS levy
- Substantially equal periodic payments
- Qualified reservist distributions
Roth vs. Traditional
- Earnings are tax-free if withdrawn at or after age 59½ and the individual retirement account has been open five years or more*
- Contributions (not earnings) can be withdrawn tax free and without the penalty tax at any time
- Contributions are not tax-deductible
- Earnings are tax-deferred until withdrawn at or after age 59½ at which time they are taxed at your current rate
- Contributions and earnings can be withdrawn penalty tax free at or after age 59½
- Contributions may be tax-deductible
*Certain restrictions apply. Fees and expenses are subject to change. Please note that other fees and expenses may apply, including early withdrawal penalties. Please review our Fee Schedule.