An important question I always get asked is “Which retirement account should I open?” Let’s talk about the differences between a Traditional IRA or a Roth IRA first and foremost. The type of individual retirement account (IRA) you choose can significantly affect your long-term savings and retirement plans, so it’s worth understanding the differences between Traditional IRAs and Roth IRAs in order to select the best one for you, that will help your family the most in retirement.
Income Limits. Anyone with earned income who is younger than 70½ can contribute to a Traditional IRA. Whether the contribution is tax deductible depends on your income and whether you or your spouse are covered by a retirement plan through your job, such as a 401(k) or 403(b). Roth IRAs don’t have age restrictions, but they do have income-eligibility restrictions: Single tax filers must have modified adjusted gross incomes(AGI) of less than $133,000 in 2017 to contribute to a Roth IRA. Married couples filing jointly must have modified AGIs of less than $196,000 in 2017 in order to contribute to a Roth. So right off that bat, your modified AGI is over 200k, a Roth IRA is out of the question for you, and you would need to find other avenues for tax deferred/free growth, such as a variable annuity.
Tax Incentives. This is the biggest difference between the two. Both Traditional and Roth IRAs provide different tax breaks. What it comes down to, is a matter of timing when you get to claim them. Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution which means, if you contribute 5000 in 2017, you take the deduction for 2017; withdrawals in retirement are taxed as ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with Traditional IRAs, you avoid taxes when you put the money in. With Roth IRAs, you avoid taxes when you take it out in retirement. Generally speaking, younger adults are better off opening an Roth IRA while they have time on their side as opposed to later in life, where you will not have the power of compounding interest work for you so long. Lastly, with both types of IRAs, you pay no taxes whatsoever on all of the growth of your contributed funds, as long as they remain in the account.
Withdrawal Rules. One major difference between Traditional IRAs and Roth IRAs is when the savings must be withdrawn. With traditional IRAs, you are required to start taking required minimum distributions (RMDs). This is a mandatory, taxable withdrawals of a certain percentage of your funds, at age 70½, whether you need the money at that point or not. The government wants their tax revenue, and you are forced to take out the cash. Roth IRAs, on the other hand, don’t require any withdrawals during the owner’s lifetime. If you have enough other income, you can let your Roth IRAs continue to grow tax-free throughout your lifetime, making them ideal wealth-transfer vehicles. The same applies to your heirs. Beneficiaries of Roth IRAs don’t owe income tax on withdrawals and can stretch out distributions over many years. However, beneficiaries may still owe estate taxes. With an inherited IRA, you have to take out RMD’s as well, and spend down the cash in the account over a certain amount of years.
Exceptions to withdrawals. Both Traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59½. Any distribution before 59 ½ gets hit with a 10% penalty. However, Roth IRAs require that the first contribution be made at least five years before the first withdrawal, in order to avoid incurring a tax payment. If you meet that benchmark (and you only have to meet it once), you will have only paid taxes on what went into the account, not the sum you eventually take out.
Traditional IRA exceptions. If you are under 59½, you can withdraw up to $10,000 from your account without the normal 10% early-withdrawal penalty to pay for qualified first-time home-buyer expenses and for qualified higher education expenses. Hardships such as disability and certain levels of unreimbursed medical expenses may also be exempt from the penalty. Just remember you will still pay taxes on any distribution.
Roth IRA exceptions. Contributions, but not earnings, can be withdrawn penalty and tax-free at any time, even before age 59½. If you are under 59½, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time home-buyer expenses, provided at least 5 tax years have passed since your initial contribution. Roth IRAs can be invested in literally anything you want: index funds, life cycle funds, individual stocks, or even alternative investments. In contrast, there are some limits to the types of assets a Traditional IRA can hold.
You are going to have to ask yourself some questions about your current and future work situation: Which federal tax bracket are you in today? Do you expect to be in a higher or lower one after you retire? Will your annual income increase or decrease through retirement? Although common sense suggests that gross income declines in retirement, taxable income sometimes does not. Think of it like this, you’ll be collecting and paying taxes on Social Security payments. You might opt to work part time. And once the kids are grown and you stop adding to the retirement nest egg, you lose some valuable tax deductions and tax credits. All this could leave you with higher taxable income, even after you stop working full-time.
It’s important to sit down with your financial advisor and accountant to see which situation works best for you.