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). [Read related article: The Solopreneur's Guide to Retirement Funds]
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."
More specifically, the traditional vs. Roth IRA choice comes down to three questions:
Do you want to pay taxes on your retirement account now or in retirement? If later, you may prefer traditional IRAs. If you prefer to pay taxes now, then the Roth IRA is the better option.
Is your modified adjusted gross income (MAGI) high? If it is, you may only qualify for traditional IRAs.
- Do you want the option of withdrawing funds before retirement or never withdrawing from your account? If so, you may prefer Roth IRAs. Otherwise, the traditional IRA likely the right choice for you.
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.
The limits that Todd refers to apply to both Roth and traditional IRAs. However, this contribution limit is one of the only things traditional and Roth IRAs have in common.
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.
In 2021, single tax filers with MAGIs of below $140,000 qualify for Roth IRA plans. This up from 2020's $139,000. Similarly, the MAGI limit for married couples filing jointly has also increased from 2020. In 2021, this limit is $208,000, up from $206,000 in 2020.
Contributions are not limited by your income, and you may be able to open a traditional IRA for a spouse who does not work. However, in either case, the IRA contribution amount you can deduct from your taxes may be limited by your income.
You can contribute to a Roth IRA at any age as long as you meet the MAGI requirements.
As with a traditional IRA, you can contribute to your retirement account at any age, but this is new for traditional IRAs. Prior to 2020, the IRS restricted people over the age of 70 1/2 from contributing to their traditional IRAs, but this requirement was eliminated last year.
Contributions to a Roth IRA are made with post-tax income. "However, when you withdraw money from a Roth IRA, it comes out tax-free as long as you meet the guidelines," Todd said.
The tax structure of Roth IRA means that you can't directly deduct any Roth IRA contributions on your taxes. However, you may qualify for the Retirement Savings Contributions Credit, also known as the Saver's Credit. You qualify if you are:
- At least 18 years old
- Not claimed as a dependent on another taxpayer's return
- Not enrolled as a full-time university student or in full-time, on-farm schooling or government training courses during any part of five months of the calendar year.
For 2021, the Saver's Credit has the following rates:
- 50% of your IRA contribution if:
- You are a single taxpayer whose AGI does not exceed $19,750
- You are a head of household whose AGI does not exceed $29,625
- You are married filing jointly and your AGI does not exceed $39,500
- 25% of your IRA contribution if:
- You are a single taxpayer whose AGI is between $19,751 and $21,500
- You are a head of household whose AGI is between $29,626 and $32,250
- You are married filing jointly and your AGI is between $39,501 and $43,000
- 10% of your IRA contribution if:
- You are a single taxpayer whose AGI is between $21,501 and $33,000
- You are a head of household whose AGI is between $32,251 and $49,500
- You are married filing jointly and your AGI is between $43,001 and $66,000
If your income exceeds the amounts outlined in the 10% bracket, you cannot claim the Saver's Credit.
Contributions to traditional IRAs are made pretax. This means they can be either partially or completely deducted from your taxes, 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.
To determine whether you can partially or completely deduct your traditional IRA contributions from your taxes, see the below 2021 IRS traditional IRA deduction guidelines:
- For single taxpayers with a MAGI of at most $66,000, IRA contributions are completely deductible. For income above $66,000 but below $76,000, traditional IRA contributions are partially deductible. Single taxpayers with a MAGI of $76,000 or more cannot deduct their contributions.
- IRA contributions are completely deductible for married couples filing jointly with a MAGI of at most $105,000. For income above $105,000 but below $125,000, IRA contributions are partially deductible. Married taxpayers filing jointly with a MAGI of $125,000 or more cannot deduct their contributions.
- A married person filing separately can claim only a partial deduction, and only if their MAGI is below $10,000. Otherwise, no deduction is possible.
Note that the Saver's Credit applies for traditional IRAs as well.
Withdrawals and distributions
You can withdraw money from a Roth IRA at any time without tax penalties. Additionally, as the account owner of your Roth IRA, you have no required minimum distribution. This means you're never required to withdraw money, though any beneficiaries you designate might face this requirement.
Withdrawals from a traditional IRA become tax-free at age 59½. Account owners and beneficiaries alike must begin withdrawing from traditional IRAs once they turn 72 years old.
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% 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% of your earnings as a sole proprietor or 25% 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."
Additional reporting by Katharine Paljug. Some source interviews were conducted for a previous version of this article.