One of the biggest decisions you must make when saving for retirement is whether to go with a traditional or Roth IRA. You're not locked into one -- you can start with one and transition to the other over time, or contribute some money to both types of accounts. But most people favor one over the other.
Traditional IRAs are popular because the money you contribute reduces your taxable income today, though you have to pay taxes on your distributions in retirement. But there are times when Roth IRAs -- which don't reduce your taxable income today, but then grow tax-free afterward -- are the better option. Here are three scenarios where a Roth IRA makes more sense.
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1. You expect to be in the same or a higher tax bracket when you retire.
When choosing between a traditional or Roth IRA, base your decision on when you'll pay the least in taxes. If you're just starting out in your career and your income is low, you're in a lower tax bracket. It makes sense to pay taxes on your retirement savings now because there's a good chance that your tax bracket in retirement could be the same or higher than it is today. If you stashed the money in a traditional IRA, you'd enjoy a small tax break this year, but you'd end up paying back far more in retirement when you're taxed on your distributions.
This is always a bit of a guessing game because you don't know how tax brackets will change or what your expenses will be in retirement. But if you anticipate spending roughly the same money in retirement as you are today (or more), a Roth IRA will save you the most in taxes.
2. You don't have to take required minimum distributions (RMDs) at 70 1/2.
For everyone 70 1/2 or older, the government has required minimum distributions (RMDs) from most retirement accounts, which generally take effect for all workers unless they're still working and own less than 5% of the company they work for. The exception is the Roth IRA. The whole point of RMDs is to force you to withdraw money from your tax-deferred retirement savings so the government can collect its share. But because you already paid taxes on your Roth IRA contributions the year you made them, your distributions are tax-free and the government has no reason to make you withdraw the funds.
Oddly enough, Roth 401(k)s, which are taxed similarly to Roth IRAs, do have RMDs. But you can avoid them by rolling over your Roth 401(k) into a Roth IRA. You may have to pay a small rollover fee to do this, but you won't owe any taxes because you already paid taxes on your contributions.
3. You can withdraw money at any time without penalty.
Traditional IRAs usually impose a penalty on top of income tax if you withdraw your funds before you're 59 1/2, unless you meet certain requirements like buying your first home or taking substantially equal periodic payments (SEPP). But you don't have to worry about this with Roth IRAs. The government's less picky about what you do with these funds since you already paid your share of taxes on them, so you can withdraw all the money that you put into your Roth IRA at any time without a penalty. But just because you can doesn't mean you should. This will seriously hurt the growth of your retirement savings, so don't do it unless you have no other choice.
It's also worth noting that the penalty-free withdrawal rule doesn't apply to your Roth IRA earnings. You could still owe income tax on withdrawn earnings if your Roth IRA is less than five years old, and you could pay a 10% early withdrawal penalty if you withdraw earnings before 59 1/2 without meeting one of the early withdrawal exceptions.
A few things to know before you open a Roth IRA
Everyone is allowed to contribute up to $6,000 to an IRA in 2019 or $7,000 if you're 50 or older. But this doesn't mean you can contribute $6,000 to a traditional IRA and $6,000 to a Roth IRA. The threshold applies to all of your IRAs, so think carefully about how you plan to divide your funds if you're using both types of accounts.
Roth IRAs also have income limits that may prohibit high earners from opening a Roth IRA directly. Individuals with a modified adjusted gross income (MAGI) less than $122,000 per year and married couples with a MAGI less than $193,000 per year are free to contribute up to the annual limit. Individuals with a MAGI between $122,000 and $137,000 and married couples with a MAGI between $193,000 and $203,000 are eligible to contribute a reduced amount according to this formula:
- Take your MAGI and subtract $122,000 for single adults or $193,000 for married couples.
- Divide the result by $15,000 for single adults or $10,000 for married couples.
- Multiply your result from Step 2 by $6,000 for 2019 (or $7,000 if you're 50 or older).
- Subtract your result from Step 3 from $6,000 for 2019 (or $7,000 if you're 50 or older). This is how much you can contribute to a Roth IRA.
So for a single adult earning $125,000, you'd subtract $125,000 minus $122,000 to get $3,000. Divide this by $15,000 and you get 0.2. Multiply this by $6,000 and you get $1,200. Subtract $1,200 from $6,000 and you get a $4,800 maximum Roth IRA contribution.
Single adults earning more than $137,000 and married couples earning more than $203,000 cannot contribute to a Roth IRA directly, but they can do so by putting money into a traditional IRA and then doing a Roth IRA conversion in the same year. It's a few more hoops to jump through, but it gets the job done.
Roth IRAs offer several unique advantages that traditional IRAs and 401(k)s don't. If any of those listed here appeal to you, consider opening a Roth IRA.
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This article was originally published on Fool.com