The Roth IRA advantage

It’s not a coincidence that Thiel opted for a Roth IRA to hold his PayPal shares: Investments in a Roth IRA grow tax-free. In Thiel’s case, ProPublica says that investment has grown to about $5 billion.

Yes, that seems unfair. But typical Americans don’t have to be Peter Thiel to take advantage of the Roth’s tax benefits.

“The rules really aren’t different for Peter, or any wealthy person, and the average person that’s out there,” says Todd Scorzafava, a certified financial planner and partner at Eagle Rock Wealth Management in East Hanover, New Jersey.

So what are those rules? Among other things, you’ll have to wait until age 59 ½ to start pulling investment income out of your Roth IRA; otherwise, it may be taxed or penalized. The account also has income limits, and an annual contribution limit of $6,000 ($7,000 if you’re 50 or older). Those who follow the rules — tech billionaires or otherwise — reap the Roth’s rewards.

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IRA Contribution Limits

The Internal Revenue Service (IRS) places limits on the amount you can invest annually in an IRA, whether you choose to go down the Roth or traditional IRA path. For 2021 and 2022, the IRA limit for contributors is $6,000 plus a $1,000 catch-up contribution for taxpayers who are 50 and over. The contribution maximums apply collectively to all your IRAs, which means they are not per account.

The IRS imposes penalties if you contribute more than the allowable annual amount to an IRA.

Traditional IRA limits

The IRS allows deductions on contributions to a traditional IRA, but the deduction may be reduced or phased out if you (or your spouse, if you file jointly) are covered by a retirement plan at work.

For the 2021 tax year, a single filer covered by a workplace plan can take a full deduction if their AGI is under $66,000 ($68,000 for 2022) or a partial one if they make between $66,000 and $76,000 ($68,000 and $78,000 for 2022). The deduction is eliminated above that amount.

A married couple in which the IRA-contributing spouse is covered by a workplace retirement plan can take a full deduction if their AGI is below $105,000 annually ($109,00 for 2022), a partial one if it's between $105,000 and $125,000 ($109,000 and $129,000 for 2022), and none if their AGI is above that amount. If the other spouse has the workplace plan, the phase-out applies to a joint income between $198,000 and $208,000 ($204,000 and $214,000 for 2022).

Roth IRA limits

Your participation in a workplace plan doesn’t affect your Roth IRA contributions. Your income, on the other hand, does. Specifically, your modified adjusted gross income (MAGI) determines whether or not you can contribute to a Roth IRA and how much you can contribute.

Single taxpayers are good to go until their MAGI hits $125,000 ($129,000 for 2022). If it falls between $125,000 and $140,000 ($129,000 and $144,000 for 2022), they face a gradual reduction of the amount they can contribute. For joint filers, the phase-out applies to incomes between $198,000 to $208,000 ($204,000 to $214,000 for 2022). Exceed those outer limits and you can't fund a Roth IRA at all.

Modified adjusted gross income (MAGI) is your AGI with certain tax deductions added back in, including those for traditional IRA contributions, interest on bonds and student loans, self-employment taxes, and foreign income.

How much does IRA save in taxes?

If you meet the eligibility criteria and are able to make the whole contribution limit of $6,000 into a traditional IRA, then you save paying tax on that amount now. The idea is that in retirement your income tax bracket may be lower, and you would be taxed at a lower rate on that money and any gains it makes when you take the distribution. For Roth IRA, while you're contributing after-tax dollars you won't be liable to pay tax when you meet certain criteria.

3. Lower-Income Workers Get an Extra Credit

The Retirement Savings Contributions Credit is another tax incentive that’s geared specifically towards people who don’t earn huge amounts of income. The credit is good for 10%, 20% or 50% of your total IRA contribution up to $2,000, or $4,000 if you’re married and filing jointly. The amount of the credit you qualify for is based on your adjusted gross income (AGI).

For the 2021 tax year, single filers get the 50% credit if their AGI isn’t higher than $19,750. Once your income passes $33,000, you’re no longer eligible for the credit. Married couples can qualify for the 50% credit with a combined income of $39,500 or less. At the $66,000 mark, the credit is phased out entirely. For heads of households, the 50% contribution is attainable with an AGI below $29,625, with a complete phase-out at $49,500.

What is the deadline to contribute?

You can contribute to an IRA at any time during the calendar year and up to tax day of the following calendar year. For example, taxpayers can contribute at any time during 2021 and have until the tax deadline (April 18, 2022) to contribute to an IRA for the 2021 tax year. This means that not only do you have to open the account by this date, you must have funded it, too.

But this long contribution window means that as soon as you have your 2021 contributions settled, you can start contributing for 2022, rather than scrambling at the end of tax season in 2023.

And if you file your taxes before you make your contribution? No big deal. As long as you make your IRA contribution before the tax deadline, you can refile your tax return and still get the tax benefit. It’s a little extra work, but definitely worth the hassle for the savings.

How an IRA Works

An IRA is a type of account that you can open for yourself with financial institutions like banks, brokerages and credit unions. Within the IRA, you can invest in a wide range of offerings like stocks, bonds, mutual funds, index funds and, if your institution offers them, banking products like certificates of deposit.

As of 2019, you can contribute up to $6,000 per year to your IRAs, or up to $7,000 if you are 50 or older. This is up from a $5,500 tax break limit for 2018 and earlier years. To reach the IRA tax break limit, you must contribute your own earned income or your spouse’s earned income, so if you earned less than $6,000 in a year, you can only contribute to the extent that you earned.

When you file your taxes, you can claim an IRA tax deduction for your contributions. How much you will save depends on how much you contribute to the plan and what your tax bracket rate is.

When you are over age 59 1/2, you can begin to withdraw money from your IRA without a tax penalty. You will then pay tax on the money you withdraw at your tax rate at the time. If you withdraw money from an IRA before age 59 1/2, you will generally have to pay tax on the funds plus a 10 percent penalty to the Internal Revenue Service unless special limited circumstances apply.

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Does a Last-Minute IRA Contribution Make Sense for You?

Just because you can make one of these last-minute IRA contributions doesn’t mean you necessarily should.

If you’re a high earner eligible for a full or partial deduction, getting a contribution under the wire could make a lot of sense. Out of all the retirement tax moves at your disposal for the previous year, you might stand to benefit from this the most.

And if you’re not in one of the higher tax brackets now? You certainly can still contribute to a traditional IRA, but your deduction may not be that great. Someone in the 12% tax bracket, for instance, might only save $720. Nothing to sneeze at, sure. But you might actually get better tax advantages in the long run from a Roth IRA.

Roth IRAs Can Save You Big on Taxes Later

A Roth IRA is funded with dollars that have already faced Uncle Sam’s wrath. That means no upfront tax deductions (and no decreases to your taxable income now), but you never have to pay a dime on withdrawals made after you turn 59 ½.

If you’re in a lower tax bracket now, then, you could save potentially upward of double of the taxes you’d owe later if you move into a higher bracket in retirement, assuming you moved from a 10% or 12% to any of the other brackets. That’s why a Roth IRA makes a ton of sense for younger earners who are in a lower tax bracket today than they’ll see once they hang up their boots.

In fact, anyone who’s able to contribute to a Roth now may stand to benefit long term. “If you’re eligible for a Roth IRA, you’re probably better off paying taxes now,” says Wealthfront certified public accountant (CPA) Tony Molina. “We’re in a period of historically low tax rates.”

Unfortunately, not everyone can contribute to a Roth IRA. Much like the traditional IRA tax deduction limits we covered earlier, there are income cut-offs that put the Roth IRA out of reach of high earners.

Roth IRA Income Limits in 2021 and 2022

Your filing status Your 2021 income Your 2022 income You may contribute:

Single, head of household or married filing separately (and you did not live with your spouse at any time during the year)

Less than $125,000

Less than $129,000

Up to the annual limit

Single, head of household or married filing separately (and you did not live with your spouse at any time during the year)

$125,000 to $140,000

$129,000 to $144,000

A reduced amount

Single, head of household or married filing separately (and you did not live with your spouse at any time during the year)

More than $140,000

More than $144,000

Zero

Married filing jointly or qualified widow(er)

Less than $198,000

Less than $204,000

Up to the annual limit

Married filing jointly or qualified widow(er)

$198,000 to $208,000

$204,000 to $214,000

A reduced amount

Married filing jointly or qualified widow(er)

More than $208,000

More than $214,000

Zero

Married filing separately

Less than $10,000

Less than $10,000

A reduced amount

Married filing separately

More than $10,000

More than $10,000

No deduction

While Roth contributions today won’t lower your taxes today, there’s more to retirement savings strategies than saving a few bucks on your tax bill in the here-and-now.

When a Traditional IRA Makes More Sense for Low Earners

Still there may be some scenarios where it makes sense for those without the biggest incomes to use a traditional IRA.

To see if these might be right for you, start by preparing your tax return to determine your adjusted gross income. Once you have that number in hand, you can see if you’re close to qualifying for an income-based tax deduction, says Mike Piper, a St. Louis-based CPA, which would make utilizing a traditional IRA more appealing to save substantially more money in the here and now.

You might even get a tax break you’ve never heard of, like the saver’s credit, which less than half of taxpayers know about but that could credit you with up to $2,000.

Double Tax Break with the Savers Credit

Some low- and moderate-income taxpayers get an extra tax break on their 2021 return for contributing to an IRA or other retirement account.

In addition to the usual IRA deduction, you may qualify for a Retirement Savers tax credit of up to $1,000 ($2,000 for joint filers) for contributions to an IRA or other retirement tax plan. (A tax credit, which reduces your tax bill dollar-for-dollar, is more valuable than a deduction, which merely reduces the amount of income that is taxed.)

Comparing tax savings: Traditional IRA vs. Roth IRA

If you’re looking for last-minute tax savings this year, you’ll want to make sure that you select the right IRA – the traditional IRA. But you should watch out because there’s another kind – the Roth IRA – that gets you tax savings in the future, rather than today.

The traditional IRA offers you a tax break today in exchange for allowing your investments to grow tax-free until retirement. When you withdraw your money in the future, you’ll pay taxes on the distributions.

In contrast, the Roth IRA gives you a future tax break because you’re saving with after-tax money today. With the Roth IRA, your investments grow tax-free and you won’t pay any taxes on qualified withdrawals later.

While these are the most substantial differences between the two IRAs, there are further differences that you’ll want to understand before making a final choice.

Investments and Tax Considerations

When you’re deciding what types of investments to hold in an IRA versus a traditional bank or brokerage account, taxes will likely be one of the factors that you consider. Note that if you hold on to stocks, bonds or real estate outside of an IRA for more than one year and then sell them for a profit, you will be taxed at the long-term capital gains tax rate rather than your ordinary income tax rate.

This rate is 15 percent for most taxpayers and 0 percent or 20 percent for others depending on your overall income. For most taxpayers, that’s less than you would pay on ordinary income, such as money you earned from work or bank interest. If you sell investments at a loss, you can deduct the capital loss from other capital gains or, to a limited extent, from your ordinary income. You can roll unused capital losses into future tax years, although you can’t roll them backward to offset prior gains.

Depending on your anticipated returns, you may decide to hold some investments in IRAs and other tax-advantaged retirement accounts and others in traditional accounts.

Which IRA to Choose?

The good news is that you don’t have to choose between a Roth or traditional IRA. There's no rule that says you can't contribute to both, but the contribution limits apply to them collectively, not individually.

It can be difficult to predict what your income and tax bracket will be when you retire, so it often makes sense to put money in both types of accounts so you'll see tax advantages either way—upfront with a traditional IRA that offers tax deductions, and on the back end with a Roth IRA that provides for tax-free withdrawals.

A traditional IRA might not be necessary if you already have access to a 401(k) or similar plan through your employer. Both of these accounts provide upfront tax deductions.

Which Is Better, a 401(k) or an IRA?

Deciding which retirement account is better, either a 401(k) or an IRA, will depend on the individual and their specific needs. A 401(k) allows for more contributions to be made than an IRA. Additionally, 401(k)s can be easier to manage, since participants generally have a range of target-date funds (TDFs) to choose from, which lets an investor put investing on autopilot. Many plans are designed to opt participants into a qualified default investment alternative, so that their contributions are automatically invested rather than sitting in cash.

Retirement Planning Tips

  • Opening an IRA is a great step towards getting prepared for retirement. However, you might also benefit from talking to a financial advisor who can help you come up with a complete plan for retirement. Luckily, finding a local financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Figure out which type of IRA is right for you. With a traditional IRA, contributions are made with pre-tax dollars. This might be good if you expect to be in a lower tax bracket after retirement. A Roth IRA, on the other hand, is funded through after-tax contributions. This makes it a good option if you think your tax rate will go up as you get older.

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