In 2019 , 50% of American households had little to no savings in their retirement accounts such as IRAs, 401(k)s, pensions, etc. Furthermore, while most American households had at least $1,000 in checking or savings accounts, only about 7% of households had more than $100,000 in savings and checking accounts as seen in the graphs below. The data indicates that a large portion of the population may have limited financial resources to rely on during retirement.
Among households approaching retirement age only 40% had at least $100,000 in financial assets, including retirement accounts, checking and savings accounts, and certificates of deposit accounts.
Retirees with insufficient retirement savings are forced to continue working in their retirement or to rely heavily on their Social Security benefits. In February 2022, the average yearly Social Security benefit was approximately $22,000 in 2023, providing about $1,833 in monthly income. Relying solely on Social Security income can lead to a significant reduction in lifestyle and quality of life in retirement years.
This article explores two popular retirement vehicles and possibly encourage the reader to start saving for retirement. Individual Retirement Accounts (IRAs) are popular investment vehicles designed to help people save for retirement. There are several types of IRAs including:
- Traditional IRA
- Roth IRA
- SEP IRA
- Nondeductible IRA
- Spousal IRA
- SIMPLE IRA
- Self-directed IRA
- Inherited IRA
- Rollover IRA
We will focus on the Roth IRA and the Traditional IRA retirement accounts. While both of them have a similar goal of providing a tax-advantaged way to save for retirement, they differ in how they are taxed and when the taxes are paid.
Traditional IRA Vs Roth IRA
A traditional IRA is a type of retirement account that allows you to save for retirement on a tax-deferred basis. This means you can deduct your contributions from your taxable income in the year you make them, which can reduce your tax bill. However, you will still owe taxes on the money when you withdraw it in retirement.
On the other hand a Roth IRA is a retirement account where contributions are made with after-tax money. This means that funds are taxed before being deposited in the account. However, the key advantage is that qualified withdrawals during retirement are tax-free, provided specific criteria are met.
Below you will find the contribution limits for a traditional IRA and a Roth IRA as well as the income limits that determine whether you can deduct your contributions or not from your income for tax purposes:
Traditional IRA & Roth IRA Contribution Limit
Traditional IRA deduction limits 2023
Roth IRA deduction limits 2023
While Traditional IRAs and Roth IRAs offer tax advantages they have key differences in how contributions and withdrawals are taxed. Understanding these distinctions can help you in making an informed decision. Here's a comparison between Roth IRAs and Traditional IRAs:
- Tax Treatment: Roth IRA contributions are made with after-tax money, while Traditional IRA contributions are often tax-deductible.
- Eligibility: Roth IRAs have income limits for direct contributions, while Traditional IRAs allow tax-deductible contributions regardless of income, though income limits can impact deductibility.
- Future Tax Rates: Roth IRAs are advantageous if you anticipate a higher tax rate in retirement, as contributions are made with after-tax money. Traditional IRAs may be beneficial if you expect a lower tax rate in retirement, as contributions may be tax-deductible.
- Estate Planning: Roth IRAs do not require RMDs during the account holder's lifetime and can be passed on tax-free to heirs. Traditional IRAs are subject to RMDs and taxes when inherited.
- Withdrawal Rules: Roth IRAs allow tax-free withdrawals of contributions at any time. For earnings, qualified withdrawals can be made after age 59½ and a five-year holding period. Traditional IRAs require minimum distributions starting at age 72 and withdrawals are subject to income taxes.
Below you will find tables mapping out the withdrawal rules for Roth IRA and Traditional IRA accounts:
Traditional IRA Withdrawal Rules
Roth IRA Withdrawal Rules
- Low-income earners: For individuals who are in the lowest tax bracket, a traditional IRA may be more advantageous because the tax deduction for contributions can help reduce their taxable income. However, if they expect to be in a higher tax bracket in retirement, a Roth IRA may be more beneficial as the tax-free withdrawals in retirement can help avoid a larger tax bill later on.
- Middle-income earners: For individuals in the middle-income range, both traditional and Roth IRAs can be advantageous, depending on their specific circumstances. Generally speaking, if you expect to be in a lower tax bracket in retirement, a traditional IRA may be more advantageous, as you can take advantage of the tax deduction for contributions now at a higher tax bracket and pay taxes on the distributions at a lower rate later. However, if you expect to be in a higher tax bracket in retirement, a Roth IRA may be more beneficial, as your contributions are post-tax and your withdrawals are tax-free.
- High-income earners: Most high-income earners do not meet the income limits to contribute to a Roth IRA. However high income earners can take advantage of Traditional IRAs. Contributions are pre-tax and withdrawals in retirement are taxed as ordinary income.
We have explored the benefits of two popular retirement vehicles: the Roth IRA and the Traditional IRA. By understanding their particular tax situation and life circumstance, individuals can make informed decisions about their retirement savings. As US data shows a large percentage of households have minimal savings for their later years so it is crucial for individuals to prioritize saving for retirement and develop a solid financial plan to ensure a secure future. Taking advantage of retirement vehicles like IRAs can contribute significantly to long-term financial security. By starting early, making regular contributions, and considering the tax advantages of different IRAs, individuals can take proactive steps towards a comfortable retirement.
Please contact us at Timbuktu Capital Management with your questions about retirement and retirement accounts. We will work with you to find solutions that fit your retirement goals and objectives.
This marks the beginning of our retirement series. Make sure to check back our website next week for the second part, where we will explore Required Minimum Distributions (RMDs) and Inherited IRAs in greater detail.