Traditional IRA or Roth IRA
The debate continues because ultimately there is no clear winner. These two different retirement accounts each have their advantages and disadvantages, and which one you choose will depend on your situation. This post will discuss each type of account, the pros and cons of each type of account, and compare the two types of accounts.. Hopefully, you will then understand which account you should open and fund.
Putting Money into a Traditional IRA
It is extremely easy to open an IRA account. You can do it at most major brokerages as it only requires filling out a handful of paperwork. You can fund the account directly with a check or a bank transfer.
The contribution limit for an IRA account is $6,000. If you are over the age of 50, you can contribute up to $7,000. The IRS gives you a catch-up provision over the age of 50 that allows you to contribute an extra $1,000.
With a Traditional IRA account, the idea is to put money in tax-free now and pay the taxes at a later date when you withdraw the money. This makes sense since your income will likely be higher during your earning years, so your tax bracket is higher. Once you retire, your income drops and so does your tax bracket. The downside to this is that you are saving taxes on your contributions only to pay taxes on your contributions and earnings later.
The before-tax money that you are contributing into a Traditional IRA account is called this because you get to take a tax deduction on the amount contributed. You contribute $6,000 into the account and you get to take $6,000 right off the top of your taxes. Of course, with the IRS it is never that simple.
The IRS has imposed limits to stop you from deducting the contribution amount if you make over a certain amount of income. These thresholds are further reduced if you are covered by a retirement plan at work. Let’s explore further.
If you are single, and not an active participant in a retirement plan at work, you can contribute the full amount and deduct the full amount. According to the Retirement Dictionary, “An active participant is someone who receives benefits under an employer-sponsored retirement plan or participates in a retirement plan.” They go on to say that if you participate in any of the following accounts, you are an active participant: qualified plan, 403(a), 403(b), SEP IRA, or SIMPLE IRA.
There are situations when you don’t think that you are participating in a retirement account, but your employer funds the account anyway. You need to check with your employer to make sure you are not an active participant.
If you are married filing jointly, and neither you or your spouse is an active participant in a retirement account at work, you can deduct the full contribution amount.
If you are married filing jointly, but your spouse is an active participant in a retirement plan at work, you can deduct the full amount up to $193,000 in income. Once your income is over $203,000, the deduction is completely phased out. Income between those levels will give you a partial deduction.
If you are single, and an active participant in a retirement plan at work, you can deduct the full amount up to an income of $64,000. Once you are over $74,000, the deduction is completely phased out.
If you are married filing jointly and an active participant in a retirement plan at work, you can deduct the full amount up to an income of $103,000. Once you are over $123,000, the deduction is completely phased out.
Just because you cannot deduct the contribution amount doesn’t mean you shouldn’t put money away in a Traditional IRA account. You will not get a tax break on that amount now, but you will when you withdraw the money in the future. The contribution amount, not the earnings, will come out tax-free. When you make nondeductible IRA contributions, you need to make sure you keep good records of those amounts. Do not leave it up to your brokerage to maintain all of that information, or you could end up paying tax on that money twice. You will also need to let the IRS know what is happening by filing Form 8606.
Taking Money Out of a Traditional IRA
According to the Nation Institute on Retirement Security, “The average working household has virtually no retirement savings. When all households are included— not just households with retirement accounts—the median retirement account balance is $3,000 for all working-age households and $12,000 for near-retirement households. Two-thirds of working households age 55-64 with at least one earner have retirement savings less than one times their annual income, which is far below what they will need to maintain their standard of living in retirement.”
To “help” you keep your retirement on track, the IRS has set some rules. They stated that you must be 59 ½ years old before you can touch your IRA money without penalty. If you prematurely withdraw money from your account, you will be forced to pay taxes on that amount plus a 10% penalty on the amount you withdraw. Obviously, this will add up to a large tax bill.
There are a few exceptions to these rules. The two biggest exemptions are withdrawals for death or disability, and withdrawals for a first-time home purchase. If you become disabled, you can withdraw the money from your IRA without penalty. If you pass away, there are no withdrawal penalties for your beneficiaries.
For a first-time home purchase, you can take out $10,000. You must use the money within 120 days of withdrawal to purchase your first home. According to the IRS, you can be a “first-time” home buyer multiple times in your life. If you haven’t owned a home in the last two years, you qualify as a first-time home buyer. In most cases, it is best to avoid taking this money out for a home down payment. You are robbing your future self of a better retirement. Sacrificing later for a better now is fine, but should be avoided in this instance. It is better to come up with a budget and saving plan to reach your home down payment.
Once you hit age 59 ½, the money is yours to do with what you want. You can take the entire amount out in one year or not take any out any money for a while. Remember, once the money comes out, it will be added to your taxable income, and you will have to pay income tax on the amount of the withdrawal. Take too much out and it could push you into a higher tax bracket making the tax hit much worse.
At the age of 70 ½, you will be required to take money from your Traditional IRA account. The IRS is done letting you kick the tax can down the road, and they want your money. The IRS has released a table that tells you how much you should take out every year. The idea is that the account will be completely empty by the time you hit your life expectancy. It doesn’t matter if you need this money or not; you are forced to take the money or pay a 50% penalty on the money you don’t take.
First, you need to start with all your tax-deferred retirement accounts. If you have multiple traditional IRA accounts, you can group those together and think of them as one account. If you have a 401k or multiple 401k’s, you cannot group those together with any other accounts. These accounts need to be thought of separately. Roth IRA accounts do not have required minimum distributions. You’ve already paid taxes on these accounts, so you are free to leave the money in the account.
Once you have the accounts figured out, you need to determine the previous year’s ending balance for each account. Again, you can combine your traditional IRA accounts as one big account. Your 401k accounts need to be accounted for separately. You will be required to take a distribution from each of these accounts.
Now that you have the account balances, you need your age at the end of the current year. Not your current age right now, or on the day you take your required minimum distribution, but the age you will be at the end of the current year.
With your age, you will use the Uniform Lifetime Table provided by the IRS to find your divisor. Use the divisor to divide your end of year account balance and get your required minimum distribution.
For example, if you are 71 years old at the end of the year, and your account balance at the end of last year was $1,000,000, your required minimum distribution will be $37,735. You arrive at that number by dividing $1,000,000 by 26.5, which is your divisor.
Putting Money into a Roth IRA
To contribute to a Roth IRA, you need to start with earned income. If you or your spouse has earned income in the form of wages, salaries, tips, bonuses, commissions, or self-employment income, you can contribute up to that amount. This does rule out a lot of younger people who are not yet working from starting their Roth IRA account.
There are also limits on the amount of earned income you can earn before you can no longer contribute to a Roth IRA. If you are single, and your income is below $122,000, you can contribute the full amount to a Roth IRA. Once your income is above $137,000, you can no longer contribute to a Roth IRA. If you are married filing jointly, you can have income up to $193,000. Once your combined income is above $203,000, you can no longer contribute to a Roth IRA.
If you are over the income limits, there are still ways to contribute to a Roth IRA. Congress won’t allow you to contribute directly to a Roth IRA account if you are over the income limits, but you can contribute to a Traditional IRA and convert the balance to a Roth IRA. Why Congress will let you convert, but not contribute directly, remains a mystery.
Taking Money Out of a Roth IRA
If you wait until after the age of 59 ½ to start distributions from the account, the money will come out tax and penalty free – all of it. That is the big bonus to using a Roth IRA. You can pay tax now on the money, when you contribute, and take out all the money tax-free.
Which is Better, Traditional IRA or Roth IRA
That alone seems like the best deal, but it is not always the case.
Let’s assume you are under the phase out limit to make a deductible IRA contribution, and under the phase out limit to invest into a Roth IRA.
When it comes to paying taxes, there are only two points in time you need to figure out. You need to know what tax bracket you are in right now, and what tax bracket you think you will be in in the future. The difference between contributions and earnings doesn’t matter. The only thing that matters is the tax brackets for when the money is going in and when the money is coming out.
Logically, this may seem wrong to you. If you put $100,000 into your retirement accounts during your life and take out $200,000, it seems like you would only want to pay taxes on the $100,000 and not the $200,000. This would always make the Roth IRA the right choice.
The problem is that you have not accounted for the taxes on your contribution. It is too easy to say you can either put $6,000 into a Traditional IRA or $6,000 into a Roth IRA, but that is not how it works. If you are in the 25% tax bracket and put $6,000 into a Traditional IRA, it will cost you $8,000 to put $6,000 into a Roth IRA. That’s because you must pay tax on that money now.
To continue with this example, let’s say you want to put $6,000 into an IRA account. You can put $6,000 into a Traditional IRA or $4,500 into a Roth IRA. These will both cost you $6,000, but you get $1,500 more in compounded growth with a Traditional IRA. If you do this for the next 30 years, you will have $180,000 in your Traditional IRA and $135,000 in your Roth IRA. Add 8% growth to your account for 30 years and now your Traditional IRA is worth $679,699 and your Roth IRA is worth $509,774. That 25% difference from the tax bracket held true from the contribution all the way to the final balance.
Now you’ve reached retirement and your tax bracket has fallen to the 15% level. After tax at retirement, your account balances would be: $577,744 in your Traditional IRA and $509,774 in your Roth IRA. This will drop the difference between the accounts to 11%; but still, the Traditional IRA wins.
If you were to be in the same tax bracket when you contributed money as you were in retirement, in our example that would be the 25% tax bracket, the difference between the two accounts would be 0%.
Use an IRA calculator, like the one from Calculator.net to learn more about how these accounts react to different tax brackets at different times.
If you are in a low tax bracket now, maybe you are just starting out your career or you are in transition, it would make sense to invest in a Roth IRA. You will want to pay the taxes now while your tax bracket is low. The problem with trying to figure out the tax brackets is that you cannot know for sure what bracket you will be in in the future. It is a big gamble to guess your future tax bracket. You have no idea what tax brackets will be present in the future, how much money you will be making in the future or any other tax rules that may be added to retirement accounts.
Most people assume that they will be in a lower tax bracket at retirement. It is at this point that we stop earning income, so it makes sense that our tax bracket will go down. Unfortunately, that is not always the case. It can be very hard to predict what the tax brackets will be in 30 years. It can be especially difficult if we are currently in a period of tax breaks.
You also must remember the income sources you could have in 30 years. Pension and social security are the two biggest guaranteed sources of income. You could end up working until 70 years old, or even later in life. You could also have multiple sources of income, cashing out stock options, or making money in a regular brokerage account. At 70 ½, you will be required to take minimum distributions from your 401k and Traditional IRA accounts. The money that you remove from these accounts counts as taxable income, which could push you into a higher tax bracket. If you add up all of these accounts and money, you could be hit with a huge tax bill in retirement and force your way into a higher tax bracket.
With so many unknowns, how does one know which account is better?
It is best not to get hung up on future tax brackets. If you find yourself in a low tax bracket now, invest in the Roth IRA. This is a safe bet.
Beyond that, we always try to focus on tax diversity in our retirement accounts. There are three types of accounts in which you could put your assets. The first type of account is an always taxable account, deferred tax accounts like traditional IRAs and 401k accounts. The next type of account is a never taxable account, such as your Roth IRA. The last type of account is your sometimes-taxable account, and that is a standard brokerage account. Too many people keep money in their always taxable accounts. That’s because they receive a 401k or other retirement plan from work and they add to a Traditional IRA on top of that. If you already have a retirement plan from work, it is a good idea to start building a Roth IRA. Spreading out your tax diversity will help you in the future.
Keeping tax diversity will give you flexibility on when and how to withdraw money out of your accounts. When you retire early, before age 70, you can start to pull money out of your Traditional IRA to lower the required minimum distributions in the future. This will lower your future tax bill, and allow your Roth IRA to continue to grow.
Spread out money between always taxable, never taxable, and sometimes-taxable accounts to give yourself tax diversity. Tax diversity is a gift that will reward you with flexibility and lower tax bills in the future.