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Saving enough money for retirement is the first step toward building your nest egg, but just as important is where you invest that money.
When it comes to investing your retirement dollars, consider not only your asset allocation, but also asset location. Should put your money in a taxable or nontaxable account? Should you set up a traditional or Roth IRA?
Millions of Americans use IRAs to save for retirement. While the majority of retirement savers have traditional IRAs, Roth IRAs—only available since 1998—have grown in popularity. New research shows savers contribute more readily to Roth IRAs than traditional IRAs, with more than 7 in 10 new Roth IRAs opened exclusively with contributions.
In contrast, traditional IRAs are largely created through rollovers from employer-sponsored retirement plans, according to new data from the Investment Company Institute.
Still many Americans may not understand the differences between traditional and Roth IRAs to determine which accounts may be best for them. Here are some key points to keep in mind:
Differences between traditional and Roth IRAs
Traditional IRAs offer the benefit of tax deferred growth since contributions are generally made with before-tax dollars and you don't pay taxes on that money until you take it out. Contributions are deductible, unless you are covered under an employer-retirement-plan and your income exceeds certain limits, but anyone can make a nondeductible IRA contribution. You're taxed at your ordinary income tax rate on the money when you take the money out. Distributions of nondeductible contributions are not taxable.
Roth IRAs are another terrific way to save and invest for retirement. But they work a bit differently. The benefit to a Roth is tax-free growth. You make after-tax contributions and earnings grow tax-free. Unlike regular IRAs, your contributions can be withdrawn tax free at any time. Earnings from a Roth account can also be withdrawn tax-free after age 59½, as long as you have held a Roth IRA for five years. You an also withdraw up to $10,000 for a first time home purchase before age 59½.
Income and contribution limits
Contributions to traditional and Roth IRAs are the same: $5,500 this year or $6,500 for those 50 or older.
Anyone under age 70½ with eligible compensation, such as wages, can contribute to a traditional IRA, but there are income limits if you are covered under an employer retirement plan and you want to take a tax deduction on your contributions. For married couples filing jointly, the income limits for deductible IRA contributions start at $96,000 (for a fully deductible IRA) and ends at $116,000 (for a partial deduction); for single filers it's $60,000 to $70,000. The closer you get to the end of the range, the lower the amount you are able to deduct.
"There is no age limit on Roth IRA contributions. You can contribute as long as you have eligible compensation, and your income does not exceed certain amounts," notes retirement expert Denise Appleby. The income limits for Roth IRAs are much higher, making them attractive to many higher income savers. Individuals filing as single and making less than $114,000 this year and married couples who make less than $181,000 and file taxes jointly are eligible to contribute the full amount to a Roth IRA. "The eligible contribution is reduced as the income gets closer to $129,000 for single filers and $191,000 for married-filing jointly. No contribution is allowed if income exceeds these amounts," Appleby said.
Why contribute to a Roth IRA
If you're deciding between contributing to a deductible IRA and Roth IRA, there a several things to keep in mind.
Roth IRAs are a great location for the assets of many savers, particularly if you think you may need to tap into those funds at some point before retirement because you can withdraw contributions from a Roth IRA tax-free at any time.
But even if you plan to keep your money earmarked for retirement, there are several reasons why Roth IRAs make sense. If you think you'll be in a higher tax bracket when you retire, especially if you're a younger worker and have yet to reach your peak earning years, then a Roth IRA is better than a traditional IRA from a tax standpoint. Also, you don't have to take required minimum distributions from a Roth IRA at age 70½ like you do from a traditional IRA. A Roth IRA is also a great estate planning tool, since you can leave the account to your heirs and stretch out distributions tax free.
On the other hand, if you think your income tax bracket will be much lower when you retire than it is now, you may be better off taking the upfront tax deduction of a traditional IRA. If you think your income tax bracket will be the same when you retire, then it's almost a wash for income tax purposes. But again, with a Roth, you aren't subject to minimum distributions and if you leave a Roth behind when you die, your heirs can stretch out their own income free tax distributions.
—By CNBC's Sharon Epperson