An IRA (Individual Retirement Account) is a savings incentive system established for self-employed people and employees of small businesses who are not enrolled in a company pension plan and can be opened by taxpayers at financial institutions such as banks. When it comes to personal financial planning, it is very important to consider pensions and investments to ensure you have enough money for your retirement. Among IRAs, Traditional IRAs and Roth IRAs are popular choices. Each has its own advantages and disadvantages, and it’s important to consider them carefully before choosing which is best for you or whether you should subscribe to both.
Common points between Traditional IRA and Roth IRA
Annual contribution limit
In 2023, the annual contribution limit is $6,500 for an individual and $13,000 for a married couple for both Traditional and Roth IRAs. If you are 50 years of age or older, you are allowed an additional $1,000 deduction per person.
Contribution recipients
Contributions to a Traditional IRA or Roth IRA can be made by individuals with earned income and their spouses (only if married filing jointly). There are no age restrictions.
Contributions within earned income range
You can contribute up to the amount of your earned income, subject to the annual contribution limit. For example, if your earned income for the year is $5,000, you can only contribute up to $5,000.
Spousal IRA for stay-at-home moms – exception
If you do not earn your own earned income, you cannot contribute to a Traditional or Roth IRA, with the exception of a spousal IRA. The spouse with earned income is allowed to make contributions on behalf of the non-working spouse, provided the couple files a joint tax return.
Penalties and exceptions for early withdrawals
Early withdrawals (withdrawals before the individual reaches age 59 1/2) are typically subject to a 10% penalty. However, there are some exceptions, so we will show some of them.
For example, the following are allowed without penalty:
・If you deposit into another IRA again within 60 days and roll over. (Only once a year)
・For withdrawals of up to $10,000 for your first home purchase.
・If the money is used to pay for qualified higher education expenses.
・If you pay your health insurance premiums after receiving unemployment compensation.
・If you use the money to pay for unpaid medical expenses that exceed a certain percentage of your adjusted gross income.
・For withdrawals of up to $5,000 dollars in birth or adoption payments.
Advantages of Traditional IRA
Deduction from income
Contributions to a traditional IRA are deductible on annual income taxes. This allows you to deduct your contributions from your taxable income, reducing your income tax payment.
However, there are income limits, and in 2023, the Modified Adjusted Gross Income (AGI) will be between $116,000 and $136,000 for married couples filing jointly (between $73,000 and $83,000 for singles), and the deduction limit will be graduated. If your modified adjusted gross income is $136,000 or more for a married couple ($83,000 or more for a single person), contributions to a Traditional IRA will not be deductible for tax purposes.
If you have Traditional IRA contributions that are not deductible due to your high income, when you withdraw your Traditional IRA in the future, the principal will be tax-free, and the investment income will be taxable. Non-deductible Tradition IRAs may be listed on Form 8606 (Nondeductible IRAs).
Tax deferral
Assets in a Traditional IRA are tax deferred, meaning you don’t have to pay taxes on the principal or investment income until you withdraw them in the future. This allows you to take full advantage of the growth of your assets.
Disadvantages of Traditional IRA
Taxation on withdrawal
Withdrawals from Traditional IRAs are subject to income taxes on the principal and investment income. If you plan to withdraw money in retirement, you should keep in mind that it will be taxed at your ordinary income tax rate upon withdrawal.
Required minimum distribution (RMD)
Traditional IRAs have a Required minimum distribution (RMD) that requires you to withdraw a certain amount starting at age 72. This may impose some restrictions on withdrawal timing.
Advantages of Roth IRA
Tax-free asset management
Contribute funds to a Roth IRA after paying taxes. Therefore, assets within a Roth IRA grow tax-free. This means that future withdrawals will not be subject to federal or state taxes. You can maximize the growth of your assets without worrying about future taxes.
However, since you will live outside the United States in retirement, withdrawals from your Roth IRA may be taxed outside the United States if you receive them in a country other than the United States, such as Japan. Therefore, if you plan to spend your retirement outside of the United States, we recommend that you cancel your Roth IRA while you are still in the United States before leaving the United States.
Drawer flexibility
After age 59½, you can withdraw funds from your Roth IRA at any time after you’ve owned the account for at least five years.
Unlike Traditional IRAs, Roth IRAs have no required minimum distribution (RMD) requirements. This can be said to be an advantage in that assets can be left to successors as a legacy without restricting the timing of withdrawals.
Disadvantages of Roth IRA
Prepayment of taxes
Contributions to a Roth IRA are tax prepaid and contributions are not tax deductible. This means your current tax liability may increase.
Income limit
To contribute to a Roth IRA, your modified adjusted gross income (MAGI) must be less than $153,000 in 2023 if you file taxes as a single person. Additionally, if married filing jointly, the amount must be less than $228,000.
Contributions to a Roth IRA are subject to income limits, and high-income earners may not be allowed to make partial or full contributions.
Summary
Commonalities between Traditional IRA and Roth IRA include annual contribution limits, eligible contributors, contributions within earned income range, spousal IRA for stay-at-home moms, and early withdrawal penalties and exceptions.
The advantage of a Traditional IRA includes income deductions and tax deferral, but you should keep in mind that there are income limits. You may not be able to deduct it because your income is high. There is also a minimum distribution amount that is taxed at the time of withdrawal and some restrictions on the timing of withdrawal.
On the other hand, the benefits of a Roth IRA include tax-free asset management and withdrawal flexibility. However, contributions to a Roth IRA are tax prepayments and cannot be deducted from income. In addition, there are income restrictions, so there are restrictions for high-income earners.
Ultimately, which retirement plan you choose depends on your personal financial situation and future plans and requires careful consideration. Make the best choice by considering taxes, withdrawal restrictions, income limits, etc.
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