Deciding Between a Roth vs. Traditional IRA
If you're looking to boost your retirement savings, it's a wise idea to open an individual retirement account, commonly known as an IRA. Though similar to 401(k) plans found in the workplace, an IRA can give workers more investment options and greater control over how their assets are managed.
In 2020, you can contribute up to $6,000 to an IRA or, if you're age 50 or older, up to $7,000. You can also choose between two IRA options: a traditional account or a Roth account.
Which one is better? "I don't think there is a hard and fast rule that (one) is better," says Steven Elwell, a certified financial planner and partner with Level Financial Advisors in Amherst, New York.
Here's what Elwell and other experts say you need to know in order to make an informed decision.
[See: 7 Ways to Lower Your Retirement Income Risk]
Roth IRA vs. Traditional IRA
With a traditional IRA, workers are investing money that has never been taxed, says Steve Sexton, a financial professional and CEO of Sexton Advisory Group, a financial firm in Temecula, California.
The IRS offers an immediate tax deduction for contributions to a traditional IRA. Money then grows tax-deferred until retirement, at which time distributions are subject to income tax. Meanwhile, contributions to Roth IRAs are made with after-tax dollars but can be withdrawn tax-free in retirement. In both cases, money withdrawn prior to age 59 1/2 may be subject to a 10% tax penalty.
"Most people are better off taking a tax hit now," says Steve Frazier, president of financial firm Frazier Investment Management in Wakefield, Rhode Island. According to him, the gains earned by money in a Roth IRA should easily make up for paying taxes upfront.
However, a Roth IRA may not be right for everyone. Continue reading below for what you should consider before opening your retirement account.
Key Tax Considerations
If you expect that your tax rate will decrease when you retire, opt for a traditional IRA. Since traditional IRAs mean immediate tax savings, it's best to contribute to one if you think your tax rate is higher now than it will be after retirement.
High-income earners may find it best to take a deduction now and pay taxes in retirement when they could be in a lower tax bracket. If a retiree passes away prior to using all the money in a traditional IRA, heirs will pay taxes on the proceeds instead.
Remember, in exchange for receiving a deduction now, the government taxes withdrawals made in retirement at a person's regular tax rate. If a withdrawal is made before age 59 1/2, the IRS also adds a 10% penalty. Regardless of whether a retiree wants the money, the government insists people begin taking a required minimum distribution, known as an RMD, at age 72.
If you anticipate higher taxes in retirement, a Roth IRA can be advantageous. In 1997, a new version of the IRA was created. Rather than receive a tax deduction for contributions, Sen. William Roth proposed allowing people to fund an IRA with after-tax money.
Since the contributions would already have been taxed, withdrawals in retirement would be tax-free. What's more, gains made on the investments could also be withdrawn tax-free. His idea was included in the Taxpayer Relief Act of 1997, and this new savings option became known as the Roth IRA.
Unlike traditional IRAs, there is no RMD for a Roth IRA. While there is still an early withdrawal fee of 10% for any gains pulled out of an account prior to age 59 1/2, workers can take out their principal payments at any time without penalty.
"If you expect your income to go up, then something like a Roth might make sense," Elwell says.
Take your current tax bracket into account. Your tax bracket is one of the most important considerations when deciding between a traditional and Roth IRA.
"In most cases, people, while working, will be (subject to) a higher tax rate than when they are retired," Elwell says. In that case, it might be best to contribute to a traditional IRA and receive a deduction while your tax rates are higher.
However, don't assume your tax bracket will be lower after you stop working. Pensions, Social Security and investments can quickly add up to replace much of a person's pre-retirement income.
[See: 10 Social Security Claiming Strategies That Work.]
Retirees also often forget or underestimate the amount of the required minimum distributions that must be taken out of traditional 401(k)s and IRAs after they reach age 72. That amount is dictated by a formula that could push a person into a higher tax bracket or make a portion of his or her Social Security benefits taxable.
Plus, the tax cuts enacted by the Tax Cuts and Jobs Act of 2017 will expire in 2025 unless Congress takes action to extend them. Frazier points to balancing the federal deficit as a potentially motivating factor for legislators to raise tax rates in the future.
"The money has to come from somewhere," he says. Currently, the federal budget has more than a $1 trillion deficit, and the national debt is nearing $23.5 trillion.
Understand when you'll need the money. Both traditional and Roth IRAs can be subject to early withdrawal penalties, but Roth accounts offer more flexibility. All money withdrawn from a traditional IRA before age 59 1/2 is subject to a 10% penalty in addition to regular income taxes, though the penalty can be waived in certain situations, such as if you're unemployed and use the money for health insurance.
However, only the gains made on contributions to a Roth account are subject to the penalty. You can take out the principal amount at any time and for any reason. Since that money has already been taxed, it isn't subject to additional income tax either.
"If you're looking for flexibility, the Roth is the superior saving vehicle for the younger generation," Frazier says.
A Roth IRA is also more flexible in retirement. Remember, you'll have to take a distribution from a traditional IRA every year after you hit age 72. That extra income will be taxable and could push you into a higher bracket.
For older workers, a traditional IRA may be a better choice, though. Roth IRAs have a five-year rule that says money must be invested for at least five years for the earnings to be withdrawn tax-free.
How to Open an IRA and Pick the Right Account for You
When it comes to selecting the right brokerage firm to manage your IRA, you'll want to look for a service that will minimize your expenses and help you find investment funds that match your risk tolerance and retirement goals.
Here are two key steps required to open an account and start reaping the benefits of tax breaks and deductions.
1. The IRS may make the choice for you. High-income families may not have a choice between a traditional or Roth IRA. Only those taxpayers who meet certain income criteria are eligible to contribute to a Roth account.
"It's possible (to be) disqualified from the Roth in the first place," Frazier says.
In 2020, those filing jointly who earn below $196,000 as a married couple can contribute up to the full Roth IRA limit. Then, the ability to contribute phases out; those earning more than $206,000 are not allowed to put money into a Roth IRA. For single taxpayers, the ability to contribute begins to phase out at incomes at or above $124,000.
Meanwhile, anyone can contribute to a traditional IRA, but for those who have access to a 401(k) or similar workplace retirement plan, contributions are only deductible for those meeting income requirements.
Single taxpayers with modified adjusted gross incomes of up to $65,000 can deduct their full contribution up to the annual limits. The deduction phases out for those earning more. The deduction for married couples filing jointly begins to phase out at income levels exceeding $104,000.
2. Select an IRA brokerage firm. When it comes to opening and funding an account, you'll need to work with a brokerage firm. You have two options: a full-service brokerage or a robo advisor.
Full-service investment firms will provide an advisor to walk you through the process of opening an IRA. These companies can be a good choice for someone who wants a personal contact with a company to answer questions and provide customized service.
A less expensive option is to use a newer automated service known as a robo advisor. Companies like Betterment and Wealthfront make it easy to open an IRA online. The service then manages assets with little oversight required by you, making them ideal for hands-off investors.
How to Convert a Traditional IRA to a Roth
The government allows workers with traditional IRAs to move money to a Roth IRA so long as they pay income tax on the converted amount.
Known as an IRA conversion, these transfers help retirees create tax diversity in their investments. Just as workers should spread their investments among funds with various levels of risk, it makes sense to diversify money between traditional and Roth accounts. That way, seniors can better limit how much taxable income they have in retirement.
[See: 10 Ways to Reduce Taxes on Your Retirement Savings.]
"When we help someone do this, we create a model that fits within their tax bracket," Sexton says.
Low-income years may be an ideal time to complete conversions since workers will be in a lower tax bracket. Since money converted is subject to regular income tax, workers may find it beneficial to convert just enough each year to avoid pushing them into a higher tax bracket.
Be aware, though, that once a conversion is completed, it cannot be undone and income taxes must be paid on the converted amount.
Key Differences Between a Traditional and Roth IRA
Traditional IRA | Roth IRA | |
Contribution Limits | -- $6,000 combined contribution to all IRAs -- $7,000 combined contributions to all IRAs for those age 50 and older | -- $6,000 combined contribution to all IRAs -- $7,000 combined contributions to all IRAs for those age 50 and older |
Tax Deduction | Yes | No |
Tax-Free Withdrawals | No | Yes |
Required Minimum Distribution | Yes, at age 72 | No |
Tax Penalty | -- 10% penalty on withdrawals taken before age 59 1/2 | -- 10% penalty on earnings withdrawn before age 59 1/2 -- Contributions may be withdrawn tax-free at any time |
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