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 an excellent first step toward a healthy financial future.
When you are traditionally employed, saving for retirement is usually straightforward: Pick a plan from your employee benefits package and remember to take your contributions with you if you move to a new job.
However, saving for retirement becomes more complicated when you own a small or midsize business. 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).
What are 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, she explained. “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, the Roth IRA is the better option.
- Do you have a high modified adjusted gross income (MAGI)? If so, you may only qualify for traditional IRAs.
- Do you want to have the option of withdrawing funds before retirement, or never withdraw from your account until you retire? If you want to make early withdrawals, you may prefer Roth IRAs. Otherwise, the traditional IRA is likely the right choice for you.
How does an IRA differ from a 401(k)?
Both IRAs and 401(k)s are retirement savings accounts, but there are some key differences. A 401(k) retirement plan is an employer-sponsored plan, while an individual establishes an IRA without an employer’s involvement.
In some cases, employers will match employee contributions to their 401(k) as an employee benefit. Having a 401(k) plan at work impacts how much of a taxpayer’s IRA contributions are deductible.
IRAs are available to people regardless of employment status and can be set up by business owners, self-employed individuals, and those without a traditional job. Distributions in retirement are tax-free for Roth IRAs, but taxable for 401(k)s and traditional IRAs. [Learn more about saving for retirement as a solopreneur.]
IRAs and 401(k)s are both investment accounts, usually with investments in mutual funds or stocks. Their value can fluctuate depending on the market and individual investments.
If you’re a small business owner with no employees, you also qualify for a solo 401(k). A solo 401(k) offers many of the same opportunities as an employer-sponsored 401(k) plan.
What are the contribution limits of Roth and traditional IRAs?
Both Roth and traditional IRAs have annual contribution limits, which may 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.
What are the income requirements for Roth and traditional IRAs?
Roth and traditional IRAs have different income requirements.
- Roth IRA requirements: Eligibility is based on your modified adjusted gross income. After you pass a certain income level, you may not be eligible to contribute to a Roth IRA. In 2022, single tax filers with MAGIs of below $144,000 qualify for Roth IRA plans. This figure is up from 2021’s $140,000. Similarly, the MAGI limit for married couples filing jointly has also increased from 2021. In 2022, this limit is $214,000, up from $208,000 in 2021.
- Traditional IRA requirements: 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.
Consult a CPA to ensure you’re maximizing your contributions. For example, making your IRA contribution at the beginning of each year, rather than waiting for just before tax day, can help your money start compounding earlier.
What are the age limits for Roth and traditional IRAs?
Age limit rules are similar for Roth and traditional IRAs.
- Roth IRA age limits: You can contribute to a Roth IRA at any age as long as you meet the MAGI requirements.
- Traditional IRA age limits: As with a Roth IRA, you can contribute to your retirement account at any age, but this development is relatively new for traditional IRAs. Prior to 2020, the IRS restricted people over the age of 70 1/2 from contributing to their traditional IRAs.
What are the tax benefits of Roth and traditional IRAs?
There are significant differences between the tax benefits and structures of Roth and traditional IRAs.
Roth IRA tax benefits
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 Roth IRA tax structure means 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 meet the following requirements:
- You are at least 18 years old.
- You are not claimed as a dependent on another taxpayer’s return.
- You are 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 2022, the saver’s credit has the following rates.
- 50% of your IRA contribution if any of the following are true:
- You are a single taxpayer whose AGI does not exceed $20,500.
- You are a head of household whose AGI does not exceed $30,750.
- You are married filing jointly, and your AGI does not exceed $41,000.
- 20% of your IRA contribution if any of the following are true:
- You are a single taxpayer whose AGI is between $20,501 and $22,000.
- You are a head of household whose AGI is between $30,751 and $33,000.
- You are married filing jointly, and your AGI is between $41,001 and $44,000.
- 10% of your IRA contribution if any of the following are true:
- You are a single taxpayer whose AGI is between $22,001 and $34,000.
- You are a head of household whose AGI is between $332,001 and $51,000.
- You are married filing jointly, and your AGI is between $44,001 and $68,000.
If your income exceeds the amounts outlined in the 10% bracket, you cannot claim the saver’s credit. You have until the personal income tax filing deadline to make your IRA contribution for the previous year if you want to get the deduction.
You can find established retirement plans that cater to self-employed business owners. Read our reviews of the best employee retirement plans to find one that benefits your unique situation.
Traditional IRA tax benefits
Because contributions to traditional IRAs are made pre-tax, you can partially or completely deduct contributions 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 2022 IRS traditional IRA deduction guidelines:
- For single taxpayers, head of household, or qualifying widow(er)s, IRA contributions are completely deductible, regardless of income.
- IRA contributions are completely deductible for married couples filing jointly or separately with a spouse who is not covered by a retirement plan at work, regardless of income.
- For married taxpayers filing jointly with a spouse who is covered by a retirement plan at work, IRA contributions are completely deductible only if the MAGI is $204,000 or less.
- These taxpayers with incomes of between $204,000 and $214,000 can only take a partial deduction, and if the MAGI is over $214,000, there is no deduction.
- 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.
The saver’s credit applies to traditional IRAs as well.
What are withdrawal and distribution rules for Roth and traditional IRAs?
- Roth IRA 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.
- Traditional IRA: Withdrawals from a traditional IRA become tax-free at age 59.5. Account owners and beneficiaries alike must begin withdrawing from traditional IRAs once they turn 72 years old.
Traditional vs. Roth IRAs at a glance
Here’s a quick reference guide to traditional vs. Roth IRAs.
|Traditional IRA||Roth IRA|
|Annual contribution limits||$6,000, or $7,000 if you are 50 or older||$6,000, or $7,000 if you are 50 or older|
|Income requirements (MAGI)||None||Under $144,000 if filing individually; $214,000 if married and filing jointly|
|Age limits for contributions||None||None, as long as MAGI is within guidelines|
|Tax benefits||Contributions may be fully or partially deductible, depending on income and filing status.||Contributions are made with after-tax income, so there are no full deductions, but you may qualify for a saver’s credit of up to 50% of your contribution, depending on your income and filing status.|
|Withdrawals and distributions||Distributions are tax-free starting at age 59.5; before then, they are taxable and incur a 10% penalty. You must start withdrawing at age 72.||You can withdraw anytime, with no tax penalties and no minimum distribution.|
What’s the right IRA for a small business owner?
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 and 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 plan options available to business owners, including a SIMPLE IRA, SEP IRA, solo 401(k), or 7702 plan. 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.”
Jennifer Dublino and Katharine Paljug contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.