If you’re rethinking your retirement planning strategy, you’re probably wondering, which is better, a Roth IRA or traditional IRA? What is the best retirement strategy for me?
As with any financial decisions, there isn’t a single answer that will work for everyone. Instead, you’ll need to weigh the pros and cons of each. This will help you decide which works best for your overall financial goals and retirement strategy.
To determine whether a Roth IRA or traditional IRA is better for you, we’ve identified the top questions you should be asking when deciding between a Roth IRA or a traditional IRA.
When Do I Pay Taxes on My Retirement Savings and How Does this Affect my Best Retirement Strategy?
Contributing to a traditional IRA will save you taxes on what you contribute today because you are permitted to deduct your contributions from your taxable income (there are limits however on how much can be contributed). Then when you withdraw money from the account after you reach 59 1/2, your withdrawals will be taxed.
The alternative approach is the Roth IRA. Which effectively works the opposite way: contributions in a Roth will not save you taxes today because the contributions are not deductible. These are “post-tax” contributions, meaning that you’ve already paid taxes on this money (presumably earned from salaried work and already taxed). However, after it grows, and you take it out after retirement, all funds are tax-free.
With a Roth, you’re taking a bet that your current tax rate is lower today than what you expect it to be at retirement. Keep in mind that how much you take out annually will determine your tax rate, where the highest tax bracket is around 37%. However, if you expect your tax rate to be lower in retirement than it is currently, a traditional IRA is the better option from a tax rate perspective. In most cases, a tax rate increase assumption is appropriate.
Why Should I Contribute to an IRA?
An IRA is a critical part of any retirement strategy because of tax-free compound growth. Compound growth is the additional increase in value from reinvesting the gains of your initial IRA contributions.
Compound growth is realized when you reinvest your earnings from stock price appreciation, dividends, and interest instead of cashing them out and allow those earnings to grow over time. Essentially you earn gains on your gains (hence, compounding).
And when it measuring compound growth, the rate of return is everything. This is often called the compound annual growth rate, or the “CAGR.”
Unlike a regular brokerage account, IRA’s are not taxed annually. In a brokerage account (think E-Trade or Betterment), all growth in the portfolio is reported on your personal income tax return and owed with the filing of your taxes every year. However, the growth in your IRA account is not taxed at all while the funds remain in that account (both Roth IRA’s and traditional IRA’s benefit from this treatment).
And because the growth from compound interest is tax-free, the IRA CAGR will always beat the same portfolio in a regular brokerage account where capital gains are taxed. You need to subtract out taxes from your net gains to calculate the correct CAGR.
The punchline is this: savvy taxpayers must understand this principle and value of tax-free growth (and take advantage).
Can Student Loans or the FAFSA Application Affect My Decision to Open a Traditional IRA vs Roth IRA?
Contributions to a traditional IRA are deductible from taxable income and therefore can be used to make strategic decisions. For example, if your monthly student loan payments are dependent on your income, then it makes sense to choose a traditional IRA so that you have a way to reduce your taxable income. This in turn lowers your monthly debt payments which can make it easier on your budget. Also, if you plan on applying to college or a graduate program where your income is factored in, a traditional IRA contribution will help you get your taxable income down on the FAFSA application.
How Much Can I Put in a Roth IRA or a Traditional IRA?
Earning limits for contributions to a Roth IRA or traditional IRA are based on your modified adjusted gross income (MAGI). MAGI is calculated by taking the adjusted gross income reported on your tax forms and adding back items such as foreign income, student loan deductions, IRA-contribution deductions, and the higher education deduction.
For 2018, you can only contribute to a Roth IRA if you earn less than a certain amount of money. In regards to single filers, the income limit is a MAGI of $135,000. For married couples filing jointly, the limit is a MAGI of $199,000. The maximum annual direction contribution to a Roth IRA is $5,500 unless you are age 50 or over. Then it is $6,500.
A traditional IRA does not have contribution limits but instead limits how much of a deduction that you can claim. For 2018, for single filers, if your MAGI is more than $73,000 you will not be permitted to take a deduction for your contributions. For married filing jointly filers, you are not permitted to take a deduction if you jointly earn more than a MAGI of $121,000.
What If I Am I High-Income Earner?
Essentially, high-income earners are mostly excluded from contributing to a Roth IRA. On the other hand, high-income earners can contribute to a traditional IRA but they are not permitted to claim a deduction. While losing the ability to deduct contributions isn’t great, it still makes sense to contribute to an IRA for the tax-deferred growth discussed in the section above.
The exception to this is the back-door Roth method (described below).
What is a Backdoor Roth IRA?
As discussed, high-income earners are largely excluded from taking deductions on the traditional IRA or are not allowed to directly contribute to the Roth IRA. But what if you could get a Roth IRA by converting your traditional IRA?
That’s the idea behind the Backdoor Roth IRA: contribute to a traditional IRA, then take those funds and convert them to a Roth IRA. Recall that high income earners are allowed to contribute to traditional IRA but can’t take a deduction. So what? By contributing to a traditional IRA, you can take those funds and move them to a Roth IRA. You now get all the benefits that come with a Roth IRA. There’s also no limit to the amount you can convert from a Traditional IRA. But beware, there are risks around this strategy that should be discussed with your tax professional.
What Are the Early Withdrawal Rules for a Roth versus Traditional IRA?
A Roth IRA allows you to make penalty-free withdrawals in certain instances such as for buying a first home or paying for college. If you need to withdraw your contributions from your Roth IRA you can do so at any time without tax or penalty as long as the 5-year rule has been met and the lifetime total of your withdrawals is $10,000.
However, this does not apply to any earnings or interest that you may have earned on your Roth IRA investments. In order to withdraw your earnings from a Roth IRA without taxes or penalties, you need to be older than 59½ years-old and you must have made the initial contributions to the account five years prior to the date (known as the 5-year rule) when you started to withdraw funds. Otherwise, you will be subject to a 10% withdrawal penalty and you will have to pay taxes on your earnings.
Under traditional IRA rules, withdrawals that are taken before age 59½ are subject to a 10% penalty and are also taxed. There are also exemptions permitted, such as for higher education, the purchase of a first home or for medical expenses and health insurance premiums. However, the difference with a traditional IRA is that once you start taking withdrawals from your account, you can’t stop doing it. You must continue to take distributions that are spread out equally over your life expectancy every year or you will face a 10% withdrawal penalty.
If your plan is to withdraw money from your IRA at some point, a Roth IRA is likely a better option. In this instance, you may end up draining your account due to the required minimum distribution rules of a traditional IRA. However, in either instance, it is important to keep in mind that the purpose of setting up an IRA is to save for retirement so you shouldn’t take withdrawals at all if you can avoid it, until you actually retire.
What Happens When I Retire?
With traditional IRAs there are required minimum distribution rules. The IRS is only going to allow you to defer taxes for so long. When you reach age 70½ you are required to take minimum distributions which must begin by April 1st of the year following when you turn 70½. You have to then take distributions every year, which means that you won’t be able to continue to grow your investments the same way.
However, between ages of 59½ and 70½, which are likely to begin your first years of retirement, you aren’t required to take distributions from the account which means that your money can continue to grow tax-deferred. If you do decide to start distributions, you can but you only pay the taxes and there is no withdrawal penalty.
Roth IRAs, on the other hand, are not subject to minimum distribution rules during the owner’s lifetime. However, if you plan on leaving your Roth IRA to beneficiaries, your beneficiaries will be required to take required minimum distributions after your death. If such distributions are not made, they will face a penalty of 50%. The fact that you will not be subject to required minimum distributions is actually one of the greatest strengths of having a Roth IRA.
Which Option Is Better for Estate Planning Purposes?
If the sole goal of setting up an IRA is so that you can leave the account funds to your beneficiaries then it is a good idea to discuss your plans with a qualified estate planning specialist in order to determine the best strategy. However, Roth IRAs can help you to avoid probate. There are several strategies that can be used to avoid estate taxes. The balance of a Roth IRA account can be distributed to an account in the beneficiary’s name within five years of your death or can be paid out as an annuity.
Can I contribute to both a Roth IRA and a traditional IRA?
Yes. You can contribute to both a Roth IRA and a traditional IRA up to the annual contribution limits. For those under 50, that limit is $5,500 and $6,500 for those over. The one requirement for contributing to a traditional IRA is that the contributor has earned income. So as long as there is earned income, and you fall under the limits described above, you can combine contributions into both accounts.
Most taxpayers know that one saves you taxes on the seed (the Roth), while the other taxes you on the harvest (traditional IRA) which makes it seem like people should make the decision based on when they are required to pay taxes.
If you’re trying to decide which option is best, our recommendation is to have both. However, you should remember that the money that you have in a traditional IRA is not fully yours. If, for example, you have $200,000, you still owe 30% (your income tax rate) to the U.S. government. On the other hand, the money in a Roth IRA is completely yours for the taking.
Please reach out to a tax advisor for more details on what would work best for you.