Do You Want a Roth or Traditional IRA?

Hello. This is Jaye again, and today we are going to talk about the choice between a traditional and a Roth IRA. We all like options: Vanilla or chocolate? Regular or decaf? In the individual retirement account space, the choice is between a traditional IRA and a Roth IRA. Both can be powerful tools in saving for retirement, but key differences make each one optimal for different investors.

Contributions: While both traditional IRAs and Roth IRAs offer tax-advantaged solution for retirement savings, they work as an essential inverse of each other. With a traditional IRA, you typically do not pay any income tax on your contribution, and your account grows tax-deferred (IRAs). With a Roth IRA, you pay the income tax now, and your account grows tax-free (Roth IRA). So do you want to pay tax now or later?

Income limitations: Anyone can contribute to a traditional IRA, but if you are eligible for a company retirement plan there are income limits to deducting your contribution. If you are eligible for a company retirement plan and your income is above these limits, your contribution will be subject to income tax. Your account will still grow tax-deferred, and you will not be subject to any income tax on withdrawals of the original contribution amount. With a Roth IRA, you are not allowed to contribute at all if your income is higher than the phaseout limits, although you are still eligible for a Roth conversion.

Withdrawals: In a traditional IRA, you owe income tax when you withdraw funds in retirement (although some exceptions apply to non-deductable contributions). The idea is that a retiree’s income tax bracket is less in retirement, and therefore your tax liability will be less when you withdraw your retirement funds. One important note is that you are required to pull out minimum withdrawals (RMD) each year after age 70½. Since you pay taxes on withdrawals from a traditional IRA, after age 70½ you can expect that you will have a portion of your account taxed each year. A Roth IRA withdrawal, in comparison, is not taxed as long as it is a qualified withdrawal.This is because you already paid taxes on your funds before contributing them to your account. So again, do you want to pay taxes now or later?

Early Withdrawals: The general rule for IRAs is that you pay a penalty and tax on any withdrawals taken before age 59½. However, like all tax rules there are exceptions, including education and first-time home purchase. With a Roth IRA, you are also eligible to withdraw your taxed contributions at any time. This added flexibility can be a huge benefit for anyone who finds their emergency fund depleted and needs access to other monies.

So which is right for you? Generally, the rule of which IRA to use depends on your current and expected future tax bracket. If you expect your tax bracket to be higher in retirement, you contribute to a Roth IRA, and if you expect your tax bracket to be lower, you contribute to a traditional IRA. This reasoning leads one to conclude that savers in the beginning of their careers, when earnings are typically lower, should use a Roth IRA and savers at the peak of their careers, when earnings are typically at their highest, should utilize a traditional IRA. However, uncertainty about future tax rates has complicated that rule of thumb. If you believe that tax rates will not remain at the current historic lows, a Roth IRA may be appropriate even if you do not expect your earnings to increase.

Like everything else in finance, the best answer may be to diversify. You are eligible to place a total of $5,000 a year ($6,000 if 50 or over) of earned income into either IRA, or you can split that contribution in any way between the two. This means that you can hedge against future tax rates by placing $2,500 in a Roth IRA and $2,500 in a traditional IRA. As your expectations about the future change, so can your contribution percentages. Each year you are able to decide into which IRA you should contribute, or how much into both. The most important thing is to take advantage of the government’s offer to let your long-term retirement savings grow tax-advantaged, and to contribute every year.

 Best regards,

Jaye