Traditional IRAs are taxed when you liquidate them in retirement, while Roth IRAs are not.
As a small business owner, you – and only you – are responsible for your retirement nest egg. Learning the difference between traditional and Roth IRAs is a good first step toward a healthy financial future.
When you are traditionally employed, saving for retirement is usually a simple matter: Pick a plan from the ones your employer has available and remember to take your contributions with you if you move to a new job.
When you own a small or midsize business, however, saving for retirement becomes more complicated. Suddenly, no one is presenting you with plans to choose from or matching your contributions. Instead, how you save for retirement is solely up to you.
If you're a small business owner who needs to start saving for retirement, it's time to learn about traditional and Roth individual retirement accounts (IRAs).
The differences between traditional and Roth IRAs
"The differences between a traditional and Roth IRA are regarding the tax benefits, age and income requirements, and withdrawal," said Alissa Todd, a financial advisor at The Wealth Consulting Group. These differences are not necessarily pros or cons, Todd said. "What could be a pro for one investor may be a con for another, so it really depends on each person's financial situation and goal."
Income requirements: Eligibility is based on your modified adjusted gross income (MAGI). After you pass a certain level of income, you may not be eligible to contribute to a Roth IRA.
Age limits: You can contribute at any age if you are eligible based on your income.
Tax benefits: Contributions to a Roth IRA are made with post-tax income. This means you can't deduct any Roth IRA contributions on their taxes, though you may still qualify for certain credits for being a "saver."
"However, when you withdraw money from a Roth IRA, it comes out tax-free as long as you meet the guidelines," Todd said.
Income requirements: Contributions are not limited by your income. You may be able to open a traditional IRA for a spouse who does not work.
Age limits: You can contribute until you are just over 70 years old.
Tax benefits: Contributions to traditional IRAs are made pretax. This means they can be either partially or completely deducted on your taxes, depending on your income. But you will have to pay taxes in retirement. "When you withdraw money from a traditional IRA, all distributions are taxed as ordinary income," Todd said.
Both Roth and traditional IRAs have annual contribution limits, which could hinder your ability to save enough for retirement if a single Roth or traditional IRA is your only investment strategy.
"If you would like to contribute more than $6,000, or $7,000 if you are over age 50, then you may need to open another retirement plan," Todd said.
How small business owners can pick the right IRA
Choosing the correct IRA for your retirement savings depends on several factors.
"The benefit of a Roth IRA is that ... withdrawals are not taxable; withdrawals don't impact Social Security [or] Medicare taxes," said Ilene Davis, CFP, MBA, author of Wealthy By Choice: Choosing Your Way to a Wealthier Future. "However, there is no guarantee that withdrawals will not be taxed in the future … My general rule is that if a client is in the 22 percent or more tax bracket and can qualify for a traditional IRA, they should take the tax breaks now."
If neither the traditional or Roth IRA seems like the best option for you, speak to a financial advisor about other retirement plans that are available to business owners, including a SIMPLE IRA, SEP IRA or Solo 401(k). These plans often allow you to contribute more than you would in a traditional or Roth IRA, though there are more eligibility requirements.
"In a SEP IRA, you can contribute 20 percent of your earnings as a sole proprietor or 25 percent as an S- or C-corp up to $56,000, which is significantly higher [than a traditional or Roth IRA]," Todd said. "Ask yourself how much you can comfortably contribute into a retirement plan without putting yourself in a tight cash flow position."
No matter what type of plan you choose, Davis says the best thing any small or midsize business owner can do to plan for retirement is to start saving as soon as possible.
"Find the type of plan that best suits your financial situation and needs, and start," she said. "And don't stop with tax-deductible or tax-advantaged plans if you can afford to invest more and still enjoy life. Often, the difference between an OK retirement and a great one is the wealth accumulated beyond retirement plans."