Traditional IRA vs. Roth: Which Should You Choose
As a U.S. taxpayer, you probably intend on investing your money in an IRA, but like most people, you are struggling with deciding whether to choose a traditional or Roth IRA. Well, we’re here to help you out of your indecision with some helpful info on what the difference is between these two options, what the criteria are to qualify for each, and the dynamics that you should consider before choosing any one of these accounts.
What is an Individual Retirement Account
IRA stands for “individual retirement account,” and most people use it to save towards their retirement by allocating certain funds to the account. IRA’s come in different variations: there’s the traditional IRA, a Roth IRA, SEP IRAs and SIMPLE IRAs. In fact, there is a wide variety of IRA financial products to choose from, including mutual funds, bonds, and stocks too.
Why Invest in an IRA?
According to most financial experts, you’d need to save up a minimum of 85% of your income, pre-retirement, to maintain the same standard of living during retirement. For most people, the 401 (k), which is subsidized by your employer, is not enough to sustain a post-retirement lifestyle, which is why it’s a good idea to contribute towards both the 401 (k) and the IRA.
With a fidelity IRA, you’ll be able to:
- Add-on to your employer-subsidized retirement fund as well as your savings
- Have access to more investment options than you would with an employer-subsidized fund
- Potentially benefit from tax-free or tax-deferred growth
To get the most out of your IRA, it’s important to contribute as much as possible to it each year and keep an eye on your investment so that you can quickly make amendments that will enable you to realize the goals you have for retirement.
What is a traditional IRA
Most traditional IRA contributions are tax deductible. For instance, if you transfer $5,500 to your traditional IRA this year, the Internal Revenue Service will not tax it, and you’ll be entitled to receive that amount back as a deduction on your income tax return. However, the withdrawals you make from the account during retirement will be considered a form of income and taxed as such. As from the year 2018, individuals are no longer allowed to make traditional IRA contributions more than $5,500, and for those over the age of 50 years, $6,500.
Also, if your income is less than $63,000 in the year 2018, whatever contributions you make to your IRA will be deductible, whereas if your income is above that amount, then only share of your IRA contributions will be deductible. If you earn an adjusted gross income of $73,000 and above, there won’t be any deductions made on your IRA contributions, except if your employer has not provided a retirement plan for you. Different rules also apply to people with different filing statuses, such as ‘head of household’ or ‘married filing jointly.’
While no tax deductions are made on Roth IRA contributions, there are certain distributions that hold a complete tax-free status. This effectively means that even though you deposit after-tax dollars into the Roth-IRA, you won’t have to pay any capital gains taxes down the line, and the amount you withdraw from the Roth IRA during retirement won’t be taxed either, which is great.
Simplified Employee Pension IRAs
SEP IRAs are specifically designed for self-employed individuals, such as freelancers, independent contractors, and small business owners. Business owners who establish SEP IRAs on behalf of their employees can contribute to these IRAs using a portion of their reported business income, which often leads to reduced tax deductions on their business income. On the downside, employees are not allowed to make any additional contributions to their own SEP-IRA accounts, and the income they receive from the account after retirement will be taxed.
The SIMPLE in Simple IRA stands for Savings Incentive Match Plans for Employees, and they’re suitable for self-employed individuals as well as small business owners. Although similar to SEP IRAs, the difference between the two is that with SIMPLE IRAs, both the employer and the employees can contribute to the account. And while contributions from both parties are tax deductible, the tax rate is quite low and places the accounts into a lower tax bracket.
How and Why Open a Roth IRA?
Setting up an IRA is a painless process, and all you need to do is to avail your data, such as your Social Security number and birthdate, for example.
The best thing about a Roth IRA is that it allows you to withdraw from it at any time without being fined penalties or taxes. And this sort of makes Roth IRAs additional savings account that you can use for really rainy days. It’s also hassle-free in that it doesn’t require minimum distributions after you’ve retired as is the case with traditional IRAs. That said, Roth IRAs do come with certain eligibility requirements based on your income bracket.
Having a Roth IRA in addition to your 401 (k) or similar employer-subsidized plan is a sensible thing to do because then you’ll have more investment options available to you, which means greater investment returns for you in the long run, especially once you’re retired.
For example, if you contribute an amount of $455 to your Roth IRA each month- which would amount to the benchmark minimum of $5,500 per annum- in 25 years, you’d earn about $400,000 based on the average annual return of 8% from the stock market.
Both the traditional IRA and Roth IRA have the same contribution limits. For instance, while it’s generally expected for one to contribute about $5,500 on their IRA each year, for the 2018 tax year, you can contribute an additional $1,000 if you’re 50 years of age or older by tax year end.
One way to choose between a traditional IRA and a Roth IRA would be to consider whether you’ll be able to receive a year-end tax break for the traditional IRA contributions that you make throughout the year. However, there are certain criteria that you must meet to qualify for making deductions off your traditional IRA contributions.
A traditional IRA is tax deductible when you earn an annual income of $63,000 or less individually or $101,000 as a couple, or if you and your spouse do not have an employee-subsidized retirement plan, irrespective of the income, you both earn. If your earnings are above the threshold mentioned, then you’ll either qualify for lower tax rates or no taxation at all.
Roth IRA contributions, on the other hand, are always non-deductible.
Contribution Age Limits
You also have to keep in mind the age restrictions placed on your IRA and whether or not they’ll allow you to add funds for as long as you wish. While Roth IRAs do not come with an age limit, traditional IRAs have an age limit of 70 ½, and individuals over that age are not allowed to make participant contributions.
Your income will also influence your eligibility for either a Roth IRA or traditional IRA. The Roth IRA, for example, does not allow for individuals that are in a certain income bracket to make contributions, and you may experience a lower contribution limit if your income is within a bracket. Speak with your tax advisor to find out how much you can and should contribute towards a Roth IRA.
For example, married couples who earn a modified adjusted gross income (MAGI) of $189,000 and below can contribute to a Roth IRA. However, taxpayers who fall within the earning bracket of $189, 000 and $199,000 will have their Roth IRA contributions phased out. Single taxpayers that fall within the $135,000 income bracket MAGI will have their Roth IRA contributions fully phased out, as well as those earning $120,000 and above of modified AGI.
Traditional IRA income limits, on the other hand, do not come with any income caps.
Required Minimum Distributions
It’s also important to understand the rules set out for required minimum distributions (RMDs) if you want to take control of the period at which you want to start distributing your retirement assets. Traditional IRAs require that you start taking RMDs the year after you turn 70 ½. This translates to decreasing your IRA balance on an ongoing basis while adding the distributed funds to your income, regardless of whether you need the amount at that time.
There are no RMD rules for Roth IRA account owners.
Tax Treatment of Distributions
You’ll also want to consider the tax treatment of distributions before you decide on either a Roth IRA or a traditional IRA. Usually, traditional IRA distributions are considered as regular income and, in most cases, are taxed as such, and if you make withdrawals before you reach the age of 59 ½, then the distributed funds could be penalized for early distribution as well.
On the upside, Roth IRA distributions are free from penalties and tax deductions. However, Roth IRA distributions still must meet certain requirements, namely;
- The distributions should only be withdrawn 5 years after making contributions to your Roth IRA. The 5-year period is calculated from the date of the first contribution you make.
- The distribution must be withdrawn under one of the following conditions:
- Turning 59 ½ years of age.
- Being disabled.
- The distribution is made out to your beneficiary upon your passing.
- If you use the distribution amount to purchase your first home (granted you do not exceed the lifetime limit of $10,000).
With the Roth IRA, you can choose to pay your taxes now while your tax rate is still relatively low so that you can take your post-retirement distributions tax-free. So, from an overall tax perspective, the Roth IRA is the better option, especially if your current tax rate is higher than the tax rate you’ll be subject to during retirement. However, if you expect to have a lower tax rate during retirement, then you might want to go with a traditional IRA so that you can get taxed now while your tax rate is higher and you’re still working.
A visit to your financial planner will give you a better perspective on which additional factors to contemplate before you choose any one of these IRAs.
Splitting Your Contribution
If you qualify for both the traditional and the Roth IRA, then you can always split your contributions between both. That said, you’ll still be subject to the IRA contribution limits set out for that particular tax year, and this includes the additional catch-up contribution made by taxpayers that are 50 years and older.
Also, you might decide to contribute the deductible amount towards the traditional IRA while the rest will go towards your Roth IRA.
However, before you decide to contribute to two IRAs, consider the maintenance fees and other costs involved in sustaining two different IRAs.
It’s generally considered sensible to combine your retirement accounts according to type, i.e., Roth IRA or pre-tax and post-tax. Not only will your contributions be easier to track, but you’ll pay less on the associated fees as well.
You can save even further on trade-related fees when you allocate bulk trades into one IRA, instead of allocating different trades in IRAs that are unconnected. Whatever you do, be sure to think about the short-term as well as the long-term benefits of each option before you make a final decision.
Deciding Which Is Better
Your ability to deduct contributions from your traditional IRA will probably be the key defining factor when the time comes for you to choose a traditional IRA and a Roth IRA. While eligibility to withdraw from your traditional IRA contributions is a sweet feature, it doesn’t necessarily make this account the best overall option. The Roth IRA also has some noteworthy benefits as well, such as having penalty-free distributions and not being restricted by the RMD rules and regulations.
Although you may contribute to your traditional IRA as required, it is your prerogative whether or not to claim the tax deduction. Like a Roth IRA distribution, the distribution amount equivalent will be tax and penalty free once you choose not to take the deduction. While income from the traditional IRA distributions will be taxed accordingly, Roth IRA distributions are completely taxed and penalty free.
Alternatively, you could choose to contribute to both the traditional and Roth IRA so that you can enjoy benefits from both accounts.