Ask a financial planner whether to save for retirement using a Traditional IRA or a Roth IRA and you may receive an unsatisfying answer: it depends. While the Roth IRA is a much-loved planning tool, whether it’s the best option for you will depend on several factors, but math is not one of them.
An investor in a 25% tax bracket that deposits $1,000 and earns an average annual return of 6% for 30 years will end up with the same after-tax $4,307.62 in either plan. If, however, there is a difference in the investor’s future tax bracket one plan will be preferable to the other in terms of accumulation. In general, if you expect your tax rate in retirement to be the same or higher than it is now, you should consider a Roth IRA. A Traditional IRA would be a better choice if you expect your tax bracket to be lower in retirement.
Taxes, however, are only part of the equation. There are several factors that may influence the decision. Let’s explore how each plan works and which might be best for you.
Roth IRA vs. traditional IRA- what’s the difference?
- Tax benefits
- Traditional IRA: the primary benefit of a traditional IRA is that your contribution may be tax deductible. High earners that are also covered by a retirement plan at work are subject to an income-based phase out, reducing or eliminating the ability to deduct their contribution. Click here for current limits. Taxes are assessed at ordinary income tax rates when you make withdrawals from your IRA.
- Roth IRA: contributions to a Roth IRA are never tax-deductible, but qualified withdrawals are not taxed. The Roth effectively insulates you from future tax increases. Because Roth contributions are not deductible, there is no deduction phase out, but there are income-based limitations that impact your ability to contribute to a Roth in the first place. Click here for current limits.
- Contribution limits
- Traditional IRA: the 2016 and 2017 contribution limit is the same- $5,500 ($6,500 for those ages 50 and over). Individuals that are age 70.5 or over can no longer contribute to a Traditional IRA, but can still contribute to a Roth IRA.
- Roth IRA: the 2016 and 2017 contribution limits are identical to those for a Traditional IRA. Those participating in an employer-provided retirement plan can make Roth IRA contributions as long as their income does not exceed the prevailing income limitations.
- Contributions for a non-working spouse: married couples that file a joint return, and meet the other qualifications, may both contribute to Traditional IRA or Roth IRA even if one spouse has no earned income. The working spouse must have sufficient income to cover their IRA contribution and the spousal contribution.
- Multiple IRAs: you may contribute to more than one IRA, but contributions are limited in aggregate to the prevailing contribution limit (currently $5,500 or $6,500 for those ages 50 and over).
- Required Minimum Distributions
- Traditional, SEP and SIMPLE IRAs: those attaining age 70.5 must begin taking required minimum distributions (RMD) by April 1st of the calendar year following the calendar year they attain age 70.5. The distributions are taxed at your ordinary income tax rate.
- Roth IRA: there are no RMD for the original depositor, but if you inherit a Roth IRA RMD rules do apply. If the account is less than five years old at the time of the account owner’s death, earnings may be taxable.
- Charitable Contributions:
For those investors with charitable inclinations, the use of Traditional IRA funds is preferable to using funds from a Roth IRA. The reason for this is simple: qualified charities are not subject to tax. The IRA may be left to a charity at your death, or, if still very much alive, you may wish to avail yourself to a Qualified Charitable Distribution.
- Roth IRA Conversion:
Those with a Traditional IRA may consider converting some or all of the funds to a Roth IRA. Tax will be due on the conversion, and be careful of the Pro-Rata Rule that treats all Traditional, SEP and SIMPLE IRAs as one IRA for conversion purposes. Our next blog post will tackle Roth IRA conversions in more depth.
- Tax-friendly distributions:
Qualified distributions from a Roth IRA are not subject to income tax and do not count toward the calculation of taxable income for Social Security. Thus, unlike Traditional IRA distributions, Roth IRA distribution will not impact the taxation of your Social Security benefits.
- Plan for your future:
Younger investors with low income, but high earning potential can benefit by establishing a Roth IRA. The current tax deduction is less meaningful, and the Roth IRA can help augment other savings in retirement.
- Avoid the Medicare surtax:
A qualified withdrawal from a Roth IRA does not count toward the calculation of Modified Adjusted Gross Income (MAGI). A clear benefit to those in higher tax brackets.
- Income Planning:
Because qualified Roth IRA contributions are not taxable, you can augment other sources of income and mitigate the taxation of other income.
- Treat your children well:
Inherited Roth IRA required minimum distributions can be received free of income tax, and will not add to the income of those inheriting the account. In the case of adult children, they may inherit the account during their peak earning years.
How to decide?
If you’re like many investors the idea of a Roth IRA is appealing, simply because of the tax-free treatment of qualified distributions. Consider, however, that the Traditional IRA may be a better choice for those who expect to be in a lower tax bracket in retirement, are charitably inclined, or benefit less from the planning flexibility afforded by the Roth IRA. Remember that it is not an all or nothing proposition, adding a Roth IRA to the mix can help you save more money for retirement, diversify the tax treatment of your retirement assets, and mitigate taxes that could reduce your retirement income stream.
John Male, CFP®, RICP®
The Gassman Financial Group
The Retirement Maven™
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