Should I contribute to a Roth IRA or a Traditional IRA? What's the difference and which is better for me?
These are all commonly asked questions that I get.
And the answer is a definite “it depends.”
As with many questions in the financial planning world, there is not a right answer, but rather the right answer for you depends upon your situation.
Pay Taxes Now or Later?
One of the primary differences between Traditional and Roth IRAs comes down to when you want to pay your taxes. Contributions into a Traditional IRA are made with pre-tax dollars meaning you get a tax deduction now. Whereas Roth IRA contributions are made with after-tax dollars. In other words, you pay taxes on the money now and there is no tax deduction for the contribution.
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Here's Why I Love The Roth IRA
The money invested grows TAX-FREE but also, (if all conditions are met) withdrawals from a Roth IRA are TAX-FREE.
In order to withdraw your money tax-free:
- Your first contribution to a Roth IRA must have been at least five years ago
- You must be at least 59 ½
If you withdraw funds prior to age 59 ½, they are taxable and subject to a 10% penalty. There are some exceptions, assuming the five-year rule has been satisfied:
- To fund a first-time home purchase (up to $10,000)
- You use the money to pay for qualified higher educational expenses
- You become disabled or you pass away
*It's important to note that YOUR contributions can always be withdrawn tax-free. In addition, Roth IRAs are not subject to required minimum distribution (RMDs) requirements.
In comparison, money invested in a Traditional IRA grows tax-deferred. When it comes time to withdraw from a Traditional IRA, money is taxed at your ordinary income tax rate. Distributions taken prior to age 59 ½ are subject to a 10% penalty unless an exception is met. In addition, Traditional IRAs are subject to required minimum distributions at age 70 ½ which is essentially when Uncle Sam begins forcing you to take distributions so he can get that tax revenue.
Roth IRAs can be a Powerful Estate Planning Tool.
Since Roth’s are not subject to the RMD rules, the money can be left to grow and left to your heirs. A Roth IRA can pass to a spouse who can then treat the account as their own with the same RMD rules. When the money is passed to non-spousal heirs, they do have to take RMDs but these distributions are not taxed.
How Much Can I Contribute?
Contributions to IRAs (regardless of the type) are limited to the lesser of $5,500 or the amount of earned income you have for that calendar year. Earned income is income for employment, including self-employment. Contributions can be split up between the two types of accounts, but the total contributed just cannot exceed the limit.
BONUS: If you're 50 or older, you're allowed to make a "$1,000 catch-up contribution" increasing your contribution limit to $6,500.
Beware of Income Restrictions
If you're not covered by an employer retirement plan, such as a 401(k), contributions to a Traditional IRA can always be made on a pre-tax basis. However, if you are considered to be covered by a workplace retirement plan, then your ability to do a pre-tax contribution is limited based upon your adjusted gross income as follows:
Adjusted Gross Income
Single/Head of Household
Up to $62,000 (Full Deduction)
$62,000 - $72,000 (Deduction Phased Out)
Over $72,000 (No Deduction Allowed)
|Married Filing Jointly|
Up to $99,000 (Full Deduction)
$99,000 - $119,000 (Deduction Phased Out)
Over $119,000 (No Deduction Allowed)
For a Roth IRA, the ability to contribute is subject to income limits as follows:
for Full Contribution
Single/Head of Household
$118,000 - $132,999
Married Filing Jointly
$186,000 - $195,999
Income above the phase-out limits prohibits any contribution to a Roth IRA.
Still confused? No worries, this stuff can be complicated.
- Check out this FREE IRA Contribution Calculator
Other Considerations When Choosing
There are a number of factors to consider when deciding which type of IRA is right for your situation.
If you are eligible to make a pre-tax contribution to a traditional IRA, is a tax deduction now more valuable to you than tax-free withdrawals down the road in retirement?
Part of the answer might hinge upon your age and your expected income level in retirement. When IRAs were first introduced it was common for our income to decline sharply in retirement. Today, it is not uncommon for our income to be as high, or in some cases higher, in retirement as when we were working.
If most of your retirement accounts are in Traditional IRAs or 401(k)s then it might be beneficial to start a Roth IRA for tax diversification against the unknown impact of future tax legislation.
Another use for IRA accounts beyond any contributions you might make, is as a destination when rolling over a 401(k), 457, or other workplace retirement account when leaving your job. Depending upon whether your company retirement account is a Traditional account or a Roth account, you will need to have the appropriate type of IRA to be able to receive the money.
IRA accounts are a great retirement vehicle. Deciding between a Traditional or a Roth account takes planning depends upon your unique situation. A fee-only financial planner can help you sort through the right type of IRA with no sales pressure. Give me a call at (785) 256-9150 or schedule your FREE initial consultation to discuss IRAs and to help you with your retirement planning efforts.
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Desmond Henry is a fee-only CERTIFIED FINANCIAL PLANNER™ professional and founder of Afflora Financial Life Planning in Topeka, Kansas. He helps the retiring/retired plan their finances and invest their money. CLICK HERE to learn more.