Traditional IRA vs. Roth IRA: Which One Is Right For You?
Key Points:
The two most common types of Individual Retirement Arrangements (IRAs) are a “Traditional IRA” and a “Roth IRA”. While they are similar in some ways, there are many important things to consider when choosing which type of account to utilize.
With a traditional IRA, your contributions may be tax-deductible. With a Roth IRA, your contributions are not tax-deductible; however, most withdrawals are tax-free.
Age 70½ is when Traditional IRAs necessitate withdrawals, or “required minimum distributions” (RMDs). Roth IRAs do not require any distributions to be made during your lifetime.
Whether money is put into a 401(k) account or hidden under a mattress, there are numerous ways to save for retirement. While the latter might work well for some, it’s not likely to be the preferred method of a Certified Financial Planner™. Instead, they might point you in the direction of an Individual Retirement Arrangement (IRA).
The two most common types of IRAs are a “traditional IRA” and a “Roth IRA”. They both have an annual contribution limit, or the maximum amount one can contribute, currently set at $5,500, plus an additional $1,000 for those over age 50.¹ Both types of IRAs also allow for tax deferred accumulation of income. These characteristics, however, are essentially where the similarities end. Because of this, there are many important things to consider when choosing which account will work best for you.
One consideration is when you prefer to pay taxes, now or later, and your current and expected tax rates. With a traditional IRA, your contributions may be tax-deductible in the year of contribution, assuming your income is below a certain level, and you do not participate in other qualified retirement plans. After the contributions are invested in the account, any income or capital gains earned on the investments are tax-deferred until you begin making withdrawals from the account. Once you start making withdrawals, after age 59½ to avoid a 10% penalty, the withdrawals will be taxed at your ordinary income tax rate applicable the year you withdraw. With a Roth IRA, your contributions are not tax-deductible; however, withdrawals after age 59 ½ are tax-free, assuming the account has been established for at least five years. Because of this difference, expected tax rates at the time of contribution and withdrawal can be a critical factor when considering these two types of IRAs. (See Figure 1 for a summary of the tax differences.)
Hypothetical Example:
Clark is 22 and starting his first job, earning $40,000. He decides that he wants to make the maximum contribution to an IRA. He is currently in the 25% tax bracket but anticipates being in the 35% bracket when he will make withdrawals during retirement. It is potentially advantageous for him to pay the lower tax rate now on his total income, and contribute $5,500 after-tax to a Roth IRA.
In addition to taxes, other factors can impact the decision on IRA account type, such as your age at the time of contribution. With a Roth IRA, you can contribute at any age if there is “earned income”. With a Traditional IRA, however, you can’t contribute after age 70½. Withdrawal requirements should also be a consideration. At the age of 70½, a Traditional IRA necessitates withdrawals, or “required minimum distributions” (RMDs), based upon a formula determined by the Internal Revenue Service (IRS). While there are some exceptions, such as the charitable contribution of an RMD, you are effectively forced to start paying taxes on the IRA balance because of these required withdrawals. With a Roth IRA, since you already paid taxes on the contributions and did not receive a tax benefit, these accounts do not require any distributions to be made during your lifetime.
Another factor that should be considered when deciding on the type of IRA best suited to your needs is your income level. In some cases, your Adjusted Gross Income (AGI) might be too high to allow for a contribution to a Roth IRA. For example, a full contribution to a Roth IRA is allowed for single tax filers with up to $120,000 of AGI in 2018. With a Traditional IRA, you can contribute at any level of income; however, the tax-deductibility of those contributions phases out above certain income limits, or if you are a participant in another qualified plan. As these limits can change annually, we help clients plan for how their income levels could affect the deductibility of their contributions.
While we have discussed just the Traditional and Roth IRAs, it is worth mentioning there are also other IRA options for some special situations. These options include the “Simplified Employee Pension” (SEP) and “Savings Incentive Match Plans for Employees” (SIMPLE) IRAs. Both are designed for small business owners, as they are easy to administer and are cost-effective. SEP IRAs are funded by the employer or self-employed person. SIMPLE IRAs require employers to either make matching contributions for employees with elective deferrals or non-elective contributions for all eligible employees. There are many other rules with respect to these types of IRAs that are beyond the scope of this article.
Please feel free to contact Capstone Financial Advisors in Downers Grove, IL to see if an IRA account could improve your retirement savings, and, if so, help you choose the right IRA for your needs. We can guide you through the process of opening an account and navigating the various tax implications and contribution limits.
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