Roth or Traditional IRA?: 3 Things to Consider
What are some differences between a Traditional IRA and Roth IRA?
Saving money over time can potentially lead to a secure financial future for you and your family. There are many different types of investment accounts and savings strategies and each offers its own benefits and considerations. Two common investment savings accounts are Traditional IRAs and Roth IRAs. People often wonder which might the right investment vehicle for their needs given their specific situation. We will outline, at a high level, some of the considerations of contributing to a Traditional and/or Roth IRA below:
Traditional vs Roth
A major difference between Traditional and Roth IRAs is the timing of taxation. Contributions to a Roth IRA are made with after-tax dollars, the money is able to grow tax free, and withdrawals are tax free as long as certain conditions are met. Funding a Traditional IRA, on the other hand, allows you to fund with pre-tax dollars which account for a current year tax deduction for dollars contributed. The account then grows tax-deferred, and future withdrawals are taxed as ordinary income as long as certain conditions are met.
1. Tax Differences
With a Traditional IRA, you receive an income tax deduction upon contribution, but you pay taxes when you withdraw money from the IRA. Traditional IRAs can grow tax deferred until age 70.5 when required minimum distributions begin and you must begin paying taxes on the required amount of these assets. In contrast, with a Roth IRA, you receive no tax deduction for contributions but withdrawals are tax-free. To determine which account will result in lower overall taxes, you must assess the current tax rate against the predicted future tax rate, personal needs, investment portfolio composition, as well as a variety of other factors.
For example, if you expect to be in a higher tax bracket in retirement, a Roth IRA might make sense since the withdrawals will be tax-free at that time. If you are in a higher tax bracket now, the deduction on your current income taxes could be more important as you may pay taxes in a lower bracket in retirement.
2. Contribution Limits
Along with having differing tax rules for contributions, Traditional and Roth IRAs also have different requirements and guidelines for making contributions. The main differences is that you can contribute to a Roth IRA at any age as long as you have earned income, whereas you must be under 70.5 years of age to contribute to a Traditional IRA. For both types of IRAs, you cannot contribute more than the amount of income you earned that year, nor can you exceed the IRS-imposed limits (2018 limit is $5,500; $6,500 if 50 or older). You may be ineligible to contribute to a Roth IRA if your income level is above an IRS imposed Modified Adjusted Gross Income (MAGI) limit and your contributions to an IRA may no longer be tax deductible if your Adjusted Gross Income (AGI) is above a certain level.
The IRS recently announced changes to 2019 contribution limits for various types of accounts. You can find these updated limits here:
3. Withdrawals
Because Traditional IRA contributions are made with pretax dollars, the IRS requires all people age 70.5 and older to take Required Minimum Distributions (RMDs) from the account. This requires the holder to withdraw a portion of their IRA each year and these funds are taxed at ordinary income rates. Roth IRAs do not have required distributions during the lifespan of the account owner. Withdrawals taken from IRAs before age 59.5 are subject to a 10% early withdraw penalty.
Your beneficiaries will also have different tax treatment for withdrawals. Both Traditional and Roth IRAs will have Required Minimum Distributions for the beneficiaries, however the tax treatment of these distributions stay the same. For instance, a Roth IRA will provide tax free dollars when withdrawn whereas a Traditional IRA will require your beneficiary to pay ordinary income taxes at their ordinary income tax rate on the dollars received.
How Should You Choose Which Account to Open?
A variety of factors must be taken into consideration when deciding which type of retirement account is right for you. Your current and future financial goals, income, savings, and predicted future costs will help you to determine which account offers the best tax benefits. For more information, please consult an Advisor at Heck Capital.
Authored by Michael Bogard, CFA on November 29, 2018
About the Author: Michael Bogard, CFA is a Business Development / Client Relationships Senior Associate at Heck Capital Advisors. Michael earned the right to use the Chartered Financial Analyst® (CFA®) designation after completing the program in 2018, fulfilling the work experience requirements, and gaining acceptance as a member of the CFA Institute. The Chartered Financial Analyst® (CFA®) charter gives a strong understanding of advanced investment analysis and real-world portfolio management skills. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.