Traditional IRA vs. Roth IRA
Picking the right type of individual retirement account can have a significant impact on your long-term retirement savings. Though many Americans are motivated to save, most do not know which retirement vehicle is right for their financial situation. When deciding which account type is best, you should consider the many different benefits and limitations of each, such as income limits, tax incentives, future taxes, withdrawal rules, etc. It is worth taking some time to understand the differences between a Traditional IRA and a Roth IRA before jumping into one.
Next to building a nest egg, the number one reason people invest in IRAs is for the tax incentives. However, a Traditional IRA and a Roth IRA treat these incentives very differently.
Traditional IRAs can be tax deductible (at both the state and federal levels) for any contributions you make within that tax year, up to the annual limit. (This deduction is not available for people participating in an employer-sponsored plan, such as a 401(k), because they receive their tax break as a pre-tax contribution). Your contributions will grow, tax deferred, until you make distributions into retirement, at which point all withdrawals will become subject to ordinary income tax.
Roth IRAs are treated a bit differently than Traditional IRAs when it comes to taxation. Roth IRAs provide no immediate tax break for contributions, but all future earnings and withdrawals will generally be tax free if all restrictions are met. So with Roth IRAs, you are essentially paying your taxes forward to benefit from tax-free distributions in retirement.
Future Tax Rates
When a client asks me which type of IRA they should open up—assuming they can qualify for both—I pose one simple question to them: “Do you think tax rates will be higher now or in the future?” Most of us will agree that taxes will more than likely be higher in the near and distant future. With the potential of higher income taxes when you reach retirement, due to either increased wages or higher tax rates, your best option would most likely be a Roth IRA with its tax-free distribution rules.
If you have any earned income and you are under the age of 70 1/2, there are no income limitations for you to contribute to a Traditional IRA. However, Roth IRAs do impose income restrictions to eliminate any abuse of the Roth IRA program. For single, Head of Household or Married Filing Separately tax filers, their modified Adjusted Gross Income must be less than $116,000 to contribute up to the annual limits. For Married Filing Jointly or Widow(er) tax filers, their modified Adjusted Gross Income must be less than $183,000 to make contributions up to the annual limits. All other incomes do not qualify to participate in a Roth IRA.
The biggest difference when it comes to Traditional and Roth IRAs is the required withdrawal restrictions. With many retirees, the biggest pain in their side is the required minimum distribution, or RMD. If you are 70 ½ or older and you have a Traditional IRA, you are required to take annual required minimum distributions each year even if you do not need the money. This is the federal government’s way of starting to tax all the contributions that have been growing tax-free. If funds are withdrawn before the age of 59 ½, there may be penalties assessed on the withdrawal.
Roth IRAs, on the other hand, do not have required withdrawals during the owner’s lifetime. So that means, unlike the Traditional IRA, if you do not need to draw income from your retirement account, it can grow, tax-free, for your lifetime. If contributions are held in a Roth IRA for a minimum of 5 years and you are over the age of 59 ½, you can withdraw funds completely free of income taxes and penalties.
Lastly, the contribution limits for both Traditional and Roth IRAs will remain unchanged in 2015. Regular annual contribution limits for both Traditional and Roth IRAs are $5,500, and if you are over the age of 50, you qualify for the catch-up provision that allows you to put away an additional $1,000, totaling the annual contribution limit of $6,500.
Though there are benefits to owning both types of IRAs, congress can decide to change the rules regarding IRA accounts at any time. Therefore, IRA guidelines could easily be different when you reach retirement.
If you own a Traditional IRA and feel you might benefit from having a Roth IRA instead, you do have the ability to convert your account. However, you will have to pay taxes on your Traditional IRA being converted just as though you were withdrawing all the money in that year. If you are considering a conversion, we would strongly suggest that you consult your tax advisor to ensure that a Traditional to Roth IRA conversion is the smart thing to do based on your current financial situation. If you don’t have a tax advisor, contact us today for a free tax consultation with one of our trusted tax professionals.