As an individual taxpayer in the U.S. looking to save for retirement inside an IRA , you may be wondering which type - Traditional or Roth - is the better option for you.
In this article we address some of the more common questions we get from clients regarding these types of IRAs and will focus on the key factors that should be considered to help you pick the right one for you.
IRA stands for Individual Retirement Account. It is simply a type of account that the IRS recognizes as having special tax treatment to help incentivize you and me to save for our own retirement in an effort to alleviate some of the pressure on government programs like social security.
An IRA is NOT an investment in and of itself, per se. Sometimes I get asked something along the lines of “What type of return can an IRA get?” or “Is investing in an IRA risky?”. These are trick questions as the IRAs themselves do not produce returns or carry risk.
Think of IRAs as wrappers - tax wrappers to be specific. Just like candies or chocolates might have wrappers, various types of investments can be placed inside special tax wrappers, or account types, like Roth IRAs and Traditional IRAs that identify them as having certain tax treatment.
It is the underlying investments that determine things like risk and return. The IRA determines how those investments are treated from a tax standpoint.
At a conceptual level, there are 3 “phases” of taxes when considering IRAs. Imagine you are going on a journey. You have a starting point, then there is the travel itself, and finally the destination. Investments go on a similar ride when they take an IRA journey. They have a starting point (Contribution), the travel itself (Accumulation), and the destination (Distribution).
Choosing between a Traditional or Roth IRA is like choosing what sort of trip you want to take. Each has similarities and differences, and each has their own pros and cons.
Very simplistically, a Traditional IRA will probably provide more benefit today whereas a Roth IRA is likely to provide more benefits down the road.
[Same for both] Generally there are two ways to get money into an IRA - Rollover Contributions and Regular Contributions.
A rollover contribution is when you roll over funds from an employer sponsored plan (401k, SEP, SIMPLE, etc). A regular contribution can be made by anyone with taxable earned income in the year of the contribution.
[Same for both] There are limitations on how much you can contribute to an IRA. The limits are the same for both kinds, and have historically increased overtime to adjust for inflation. Contribution limits are currently set at $5,500 for the 2018 tax year. Those who turn age 50 before the end of the tax year can also make an additional $1,000 “catch up” contribution.
These limits only apply to regular contributions. Rollovers do not count against your allowable contribution limits for the year.
[Traditional] You can no longer contribute to a Traditional IRA once you reach age 70½
[Roth IRA] You can contribute to a Roth IRA regardless of age.
[Traditional] If the ability to reduce your taxes today is your primary priority when funding an IRA, then a Traditional IRA may be the route for you assuming you meet certain requirements.
If you or your spouse are covered by a retirement plan at work, then your ability to deduct contributions to a Traditional IRA may be limited depending on how much your earn. For 2018, if you are single and make less than $63,000, or are married filing jointly and make less than $101,000, you can deduct the the full amount of your contribution. Above those amounts the deductibility starts to phase out, and above $73,000 (single) and $121,000 (married filing jointly) there is no deductibility.
If you or your spouse are NOT covered by a retirement plan at work then you can deduct the full amount of your contribution (up to the limit) regardless of your income.
[Roth] Regardless of income or any other variable, you receive zero tax deduction for contributing to a Roth IRA.
[Traditional] As discussed in the previous section, when it comes to Traditional IRAs, income limitations have more to do with whether or not your contributions will be tax deductible.
[Roth] If you are single and make less than $120,000, or married and make less than $189,000, then you can make a full $5,500 ($6,500 if over age 50) to a Roth IRA. Above those income amounts you begin to quickly phase out. Above $135,000 and $199,999 respectively, you are completely phased out and can no longer make regular contributions to a Roth.
Rollovers and Roth Conversions are not subject to these limitations. Your income level does not impact your ability to rollover an old Roth 401(k) or if you want to convert a Traditional IRA to a Roth IRA.
[Same for Both] During the accumulation phase, both Roth and Traditional IRAs grow without tax consequences. Regardless of account type, none off your gains will be taxed. In a Traditional IRA this is simply a tax deferral, it doesn’t mean that there won’t ever be tax, it just means that it won’t be today.
[Traditional] Distributions from a Traditional IRA are taxed as ordinary income, and that tax applies to the entire amount distributed as those dollars have never been taxed previously (remember that deduction you got when the contribution was made?).
If the distribution is made before age 59½ then you will likely also be subject to an additional 10% early withdrawal penalty.
[Roth] Qualified distributions from a Roth IRA are generally 100% tax & penalty free. That freedom from tax applies to the entire account balance. To be qualified, two tests must be passed:
[Traditional] The perk of not having to pay taxes on your Traditional IRA money doesn’t last forever. Like all too many good things, your tax deferral comes to an end.
At the magical age of 70½, the IRS’s generosity starts wearing off and the piper comes calling, and the piper gets paid. And there isn’t much you can do about it. It doesn’t matter if you don’t need the money, you will be required to take out a minimum amount known as a Required Minimum Distribution or RMD.
[Roth] Required Minimum Distributions do not apply to Roth IRAs. In fact you don’t ever have to touch the money, unless you want to of course! With a Roth IRA you're in complete control.
The short answer is: it depends.
All things being equal (which they never are) a Roth IRA is generally better in my opinion. One caveat to that would be if you are a high income earner with a relatively short runway to retirement, and you anticipate being in a significantly lower tax bracket in retirement. In most other scenarios, a Roth IRA is likely to be a great decision (assuming you can contribute).
"Rollovers do not count against your allowable contribution limits for the year"
To really determine which is best for you be sure to talk with your financial planner and tax advisor. With that said, if your goal in saving for retirement is to make retirement as enjoyable and stress free as possible then figuring out how to get as much money in a Roth IRA as you can is probably a good move.
Our clients who are currently in retirement have far less stress around their Roth IRAs then they do around their Traditional IRAs.
Think about it. With their Traditional IRAs we have to be concerned about what tax rates are doing and calculating required minimum distributions every year. With their Roth IRAs, they don’t have any of those concerns. Whatever they need they can get tax free, and whatever they don’t need can go to their spouse or kids without tax.
Regardless of where you save or how you save, just save! We can always help you get fancier!