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Posted on July 12, 2019

Should you invest in a Roth or Traditional IRA?

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By Beth Schanou, JD

Multiple retirement savings vehicles are available but having options can be overwhelming. Each option comes with different rules leading to a variance of outcomes in the short-term and long-term. It’s not that dissimilar to choosing what to eat. There are options which are satisfying in the short-term but may necessitate a more vigorous workout later to compensate. Other menu options might be less satisfying immediately but reduce the need to work out as intensely. Similar to how different foods affect the way the body is fueled, retirement contribution choices affect the fuel for retirement. How you save is just as important as how much you save.

One example of two similar, yet very different, retirement saving vehicles are Traditional IRAs and Roth IRAs. Both are Individual Retirement Accounts meaning the account is opened and funded by the worker and are tax-advantaged accounts designed for retirement savings.  Certain other types of retirement accounts are sponsored by employers and can be funded with both worker and employer contributions. Traditional and Roth IRAs can be distinguished by their tax treatment. So how do they differ and how does each fuel retirement?

Traditional IRA

The Traditional IRA is what usually comes to mind when hearing about an IRA. Often, it’s simply called an IRA, whereas a Roth IRA goes by its full name or Roth for short. The features commonly associated with an IRA include tax-deductible contributions and tax-deferred growth.  Because contributions are made during income-earning years for a time when earned income ends or is reduced (and tax liabilities are frequently lower), the IRA can be a nice way to reduce the current income tax liability while also targeting retirement saving goals.

Traditional IRAs provide tax benefits at the point of contribution for those within the income limits for qualification of a tax deduction. Whether an employer-sponsored retirement plan is offered affects the income limits for contribution deductibility. In 2019, for example, the Modified Adjusted Gross Income (MAGI) limits are as follows:

Single / Head of Household Married Filing Jointly Married Filing Separately
No Employer Retirement Plan No Limit

Phase Out

$193,001 – $202,999

 

No Limit if spouse is not covered by a plan

Phase Out

$1 – $9,999

 

No Limit if spouse is not covered by a plan

Employer Retirement Plan

Phase Out

$64,001 – $73,999

Phase Out

$103,001 – $122,999

Phase Out

$1 – $9,999

If MAGI exceeds the limits to qualify for an income tax deduction, contributions to a Traditional IRA can still occur. The nondeductible IRA contributions will not provide in an income tax deduction, but the account will still benefit from tax-deferred growth.

The trade-off for tax-deductible contributions is taxable distributions. IRA distributions can occur at any time but may be subject to an additional 10% penalty if the account owner is under age 59½. Distributions of pre-tax contributions and the earnings are includible in taxable income.  Alternatively, nondeductible contributions increase basis in the account and distribution of the basis is not taxable. The earnings, however, on non-deductible contributions are taxable.  Leaving the assets inside the account to avoid taxable distributions cannot continue indefinitely.  At age 70½, a minimum amount must be distributed from Traditional IRAs. These distributions are known as Required Minimum Distributions (RMDs), and the penalty for failure to take the distribution is 50% of the short-fall.

Roth IRA

Like the Traditional IRA, the Roth IRA (Roth) benefits from tax-deferred growth. Unlike the Traditional IRA, Roth contributions are NOT tax-deductible. Roth accounts, however, have two attractive features the IRA does not offer:  tax-free distributions and no RMD necessity.

Because minimum distributions are not required, Roth accounts can benefit from tax-deferred growth until the account owner chooses to take a distribution.  Roth assets can be used to manage taxable income during retirement by providing a tax-free stream of income and funds not withdrawn before death maintain their tax character for the account beneficiary.

Only qualified Roth distributions are tax-free and penalty-free so it’s a good idea to know the requirements for a distribution to be qualified:

  • Over age 59½ AND at least 5 years has passed since the Roth was first opened and funded
  • Death or disability
  • Qualified first-time home purchase

Non-qualified distributions are subject to a 10% penalty unless an exception applies:

  • Distributions part of a series of substantially equal payments (greater of 5 years or age 59½)
  • Unreimbursed medical expenses exceeding 10% AGI
  • Medical insurance premiums after a job loss
  • Distributions not more than qualified higher education expenses (self or eligible family)
  • Distributions due to an IRS levy
  • Qualified reservist distribution
  • Qualified disaster recovery assistance distribution

Not everyone is eligible to contribute directly to a Roth IRA.  Income limits, based on MAGI, exist as follows:

Single / Head of Household Married Filing Jointly Married Filing Separately

Phase Out

$122,000 – $136,999

 

Phase Out

$193,000 – $202,999

Phase Out

$1 – $9,999

Individuals not eligible to save directly into a Roth IRA could consider a backdoor Roth IRA contribution. The backdoor Roth contribution is a 2-step process beginning with a non-deductible contribution to a Traditional IRA.  Then the contribution is immediately converted to a Roth. Individuals with existing Traditional IRA balances, especially if the result of tax-deductible contributions, should work closely with their CPA because the conversion could be a taxable event.

For those eligible to make tax-deductible IRA contributions and full Roth IRA contributions, it can be tough to decide to which account to contribute or the best combination among the two.  The maximum contribution amount to Traditional and Roth IRAs in 2019 is $6,000, and those age 50 and over may also make a catch-up contribution of an additional $1,000. That $6,000 contribution can be made entirely to a Traditional IRA, entirely to a Roth IRA, or some combination of the two as long as the contribution amount in total does not exceed the limit and catch-up amount, if applicable.

Just as dietary choices have short-term and long-term implications, Traditional and Roth IRA contributions have variances in their short-term and long-term impact.  Choosing where to save is best done with careful consideration, and it all starts with making the decision to build wealth for the future.  For more free information, download a free guide for additional insights.

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