Roth IRA vs. Traditional IRA: Which Is Right for You?
Back in the era of corporate pensions, U.S. workers didn't have to worry much about their account structure and how to optimize tax treatment of savings.
Of course, that day is long gone, and Americans are faced with daunting choices about their retirement savings. In addition to choosing portfolio allocations on their own, they have to decide what kind of structure to use for their investments.
When saving for retirement outside of an employer-sponsored qualified plan such as a 401(k) or 403(b), many Americans choose an individual retirement account, which offers tax advantages. However, there are a number of rules about IRAs investors must understand. Not understanding those can be costly, says Kathy Shultz, founder of Shultz Financial Planning in Beaverton, Oregon.
"People don't usually know all the rules about IRAs, and there are lots of areas that can become a trap," she says.
With a traditional IRA, contributions may be tax-deductible. Earnings grow tax-deferred, and account owners pay taxes when they withdraw money. That generally happens in retirement. Account owners must be under age 70½ to contribute. There are no income restrictions on contributions, but account owners must start taking required minimum distributions at age 70½.
With a Roth IRA, there are no age restrictions for contributions, which are made with after-tax dollars. Earnings may be withdrawn tax-free and without penalty after age 59½, provided the account has been open for at least five years. Unlike traditional IRAs, Roth IRAs have no required minimum distribution.
However, there are income restrictions with a Roth IRA. For tax year 2014, you may not be eligible to contribute to a Roth IRA if your income is over $129,000. That goes up to $131,000 for 2015. For married couples filing jointly, those limits are $191,000 in 2014 and $193,000 in 2014. You have until April 15 of this year to make IRA contributions for 2014.
In addition, if your annual income falls into what's called the "phase out" range, you can only make prorated Roth IRA contributions. That range is from $116,000 to $131,000 for a single filer, and $183,000 to $193,000 for joint filers.
Workers whose income is too high to qualify for a Roth have to use a traditional IRA. However, financial advisors say some early planning regarding IRA contributions can reduce tax headaches after retirement.
Most Americans focus on reducing their tax bill in any given year, and don't give a thought to long-term tax strategies. That can lead to problems. For example, Jennifer Cole, an investment advisor and financial planner at Cole Financial Consulting, based in Sandia Park, New Mexico, says people can save in such a way that their income actually goes up in retirement.
She cites an example of a couple who were excellent savers, but stashed everything away in tax-deferred accounts. "By the time retirement gets here, between the required minimum distributions and Social Security, their taxable income was actually going to be higher because they took out so much on a pretax basis in their working years," she says.
The lesson, Cole says, is to avoid heavy taxation in retirement by balancing contributions to tax-deferred and non-tax-deferred accounts.
Investors shouldn't automatically assume they will be in a more favorable tax situation after retirement, Shultz says. "People don't realize that when you are young and have a family, you have things that can help reduce your tax bill, like mortgage interest and child tax credits," she says. "But there aren't as many things that can help you like that when you retire."
That's an example, she says, of how a Roth IRA may alleviate future tax obligations. Carol Berger, owner and president of Halcyon Wealth Management in Peachtree City, Georgia, also advises clients to use both traditional and Roth IRAs, as appropriate.
She cites a situation in which people contribute to a 401(k) at work, and therefore may not be eligible for a tax deduction in a traditional IRA. "So they may have to go the Roth route" if they want to save beyond the 401(k), Berger says.
"The main reason I like to get people to contribute to the Roth is so they have more choices when it comes time to retire and start taking their distributions," she says.
Those choices allow for better tax planning when it's time to withdraw from various accounts in retirement. Berger has also used nondeductible IRAs, a strategy that is not particularly well-known. In one case, a client's high income made him ineligible for a Roth IRA, but he wanted an additional savings vehicle.
"So we discussed a nondeductible IRA, where you can set money aside and it grows for you. When you're ready to do your distributions, it will be there for you tax-free," she explains.
Another common situation arises when people want to convert a traditional IRA to a Roth IRA. This can be advantageous, as future withdrawals would be free of federal income tax, and there are no required minimum distributions. It's also a way to leave a tax-free inheritance to heirs, as long as the account has been open for at least five years.
However, investors who convert a traditional IRA to a Roth face a tax bill on the amount that's converted. Because of the tax consequences, Cole says, "The best time to do a Roth conversion is when you have lower-than-normal income."
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