Written by: Sarah Caine, CFP®
You’re working, and you have some extra money to invest. You’ve heard that IRAs offer a good way to save money tax-deferred. The problem is, there are two types of IRAs: Traditional and Roth. Which one is better? How do you choose which one to invest in?
Which one is best for you depends on your circumstances. Let me explain how each type of IRA works, and you’ll see why.
Things Common to Both Traditional and Roth IRAs:
How Much Can I Contribute? There are two upper limits to the amount you may contribute up to an IRA in 2020. You may contribute the LESSER of: $6,000 ($7,000 if you are age 50 or older) or the amount of income you earned. In other words, if you earn $50,000 in 2020, you may contribute up to $6,000 ($7,000 if you are age 50 or older). If you earn $4,000, the most you can contribute to your IRA is $4,000.
What about Tax-Deferral? For as long as the money remains in your IRA, it grows tax-deferred. You don’t pay tax on any income, dividends, or capital gains your IRA investments earn. This is great because it lets your account balance grow more quickly.
What about My Spouse? He or She Isn’t Working. Can He or She Still Contribute to an IRA? If you are working, eligible to fund an IRA, and filing a joint tax return with your spouse, you can both contribute to an IRA as long as your income equals or exceeds the total amount contributed to both IRAs.
These are the main similarities. Now let’s explore some of the differences between Traditional and Roth IRAs.
Things Unique to Traditional IRAs:
Can I Contribute? Anyone with earned income can contribute to a Traditional IRA.
Do I Get a Tax Deduction For my Contributions? If your Modified Adjusted Gross Income (MAGI) is below a certain level, you can get a tax deduction for your contributions.
Use this link if you’re covered by a retirement plan at work.
Use this link if you are NOT covered by a retirement plan at work OR if you are married and only one spouse is covered by a retirement plan at work.
What About When I Take Money Out During Retirement? Are Withdrawals Taxable? Withdrawals are taxable. You will pay ordinary income tax on all earnings and on any contributions for which you originally received a tax deduction.
What If I Take Money Out Before Retirement? Will I Pay a Penalty? If you withdraw money before age 59 ½, you will pay a 10% federal penalty tax on all withdrawals – plus the ordinary income tax mentioned above. There are some exceptions to the penalty tax.
Will I Have to Take Required Minimum Distributions (RMDs)? Yes. Once you turn 72, you will need to take an RMD every year.
Things Unique to Roth IRAs:
Can I Contribute? In order to contribute to a Roth IRA, your Modified Adjusted Gross Income (MAGI) needs to be below income phase-out ranges that are set by the IRS. In 2020, Roth IRAs phase out between $124,000 – $139,000 for people filing Single or Head of Household and between $196,000 – $206,000 for people filing Married Filing Jointly. If your income falls within the phase-out range, you may make a partial contribution.
Do I Get a Tax Deduction For my Contributions? No. There is no current tax deduction for contributions to a Roth IRA.
What About When I Take Money Out During Retirement? Are Withdrawals Taxable? No. Withdrawals during retirement are tax-free.
What If I Take Money Out Before Retirement? Will I Pay a Penalty? Once your Roth IRA has been in place (open and funded) for five years, you may withdraw the amount of your contributions tax and penalty-free at any time. Withdrawals of earnings before age 59 ½ could be subject to a 10% penalty; however, there are some exceptions to the penalty tax.
Will I Have to Take Required Minimum Distributions (RMDs)? No. Roth IRAs are not subject to RMDs during your lifetime.
Now What?
Now I Know how Roth IRAs and Traditional IRAs are Different. Which is Better for Me? This is largely a numbers game, and the biggest factors are age and tax brackets.
Age: The younger you are, the more likely a Roth IRA will be the better choice, and the reason is time. If you contribute $6,000 to an IRA today and let it grow at 6% interest, in 40 years, it will be worth $61,714. Which is better? Deducting $6,000 of income from your tax return now (Traditional IRA) or receiving $61,714 tax-free in 40 years (Roth IRA)? If you are close to retirement, the answer is not as clear cut. Over a 10 year timeframe, your $6,000 will only grow to $10,745 at 6% interest – so getting the tax break now or later is a much tougher call. This brings us to the next factor:
Tax Brackets: This is harder to quantify because, while you know what your tax bracket is now, you don’t know what your tax bracket will be years from now, in retirement. Even if you estimate how much you expect to earn in retirement, both the tax rates and the tax brackets will likely change (maybe more than once!) before you retire. However, in general, if you are in a high tax bracket now, and you expect to be in a low tax bracket during retirement, getting a tax break now could be more valuable to you than waiting to get a tax break in the future (so it’s best to contribute to a Traditional IRA). And conversely, if you are in a low tax bracket now, and expect to be in the same or a higher tax bracket during retirement, the future tax break will be more valuable (so go with the Roth IRA).
Balance: There is a lot to be said about balance when it comes to retirement planning. If you have a 401(k) or 403(b) through your employer, you are likely already putting money away pre-tax that will count as taxable income during retirement (similar to a Traditional IRA). Even if you are taking advantage of a Roth component built into your employer’s retirement plan, any money your employer is contributing to the plan (and the earnings on it) will be taxable upon withdrawal. In this case, adding a Roth IRA helps you diversify your tax risk. It allows you to balance withdrawals from a taxable bucket and a tax-free bucket in retirement, and gives you another tool to keep total taxes in line.
If you need help deciding which account is right for you, talk to your Financial Strategist.