Find out which type of IRA is right for you and the best investments to have in them.
My last post was an introduction to traditional and Roth IRAs. This week we’ll go beyond the basics and I’ll help you figure out something that lots of people get stuck on: whether you should invest in a traditional or a Roth IRA.
Quick Review of Traditional and Roth IRAs
But first, here’s a quick IRA review. If you have earned income (or a spouse with earned income) you can contribute to a traditional IRA, to a Roth IRA, or to both. You can even max out a workplace retirement plan, like a 401(k), and still contribute to either type of IRA—as long as your total contributions don’t exceed your allowable limit.
If you’re a high-earner, and have modified adjusted gross income (MAGI) above $120,000 or $177,000 if you’re married and file a joint tax return, then you cannot contribute to a Roth IRA. If your income is too high, you can keep an existing Roth or even convert a traditional IRA into a Roth, but you’re not allowed to make new contributions to the account or to fund a brand new Roth account.
Should You Invest in a Traditional or a Roth IRA?
Okay, so if you’re eligible to contribute to either a traditional or a Roth IRA, which one should you pick? I’ll summarize the advantages and disadvantages of each one, so you can see how they might apply to your situation.
Advantages of Traditional IRAs
Let’s start with the advantages of a traditional IRA:
You save money on taxes the year you make contributions unless you, or a spouse, also have a retirement plan at work. In that case, the tax deductibility of contributions is reduced if you reach certain income limits.
You can defer taxes until a time when you expect to be in a lower tax bracket. If you believe that you’ll earn substantially less money during retirement than you do now, then you might have a lower tax rate in the future. So paying less tax on your future withdrawals than on current contributions (as with a Roth IRA) could make sense. If you’re middle-aged or feel that your career earnings have peaked, it’s possible that a traditional IRA will save you money on taxes.
You have some flexibility about when you’ll pay tax on your contributions and earnings with a traditional IRA. You can begin to take qualified withdrawals and, of course, pay tax on them beginning at age 59½.
You’ll never have to worry about being taxed twice. Some speculate that the government could decide to tax all or a portion of Roth IRA distributions in the future—even though taxes were already paid on contributions up front. Since you only pay taxes on traditional IRA withdrawals and not on contributions (as with a Roth IRA), that may give you some peace of mind.
Disadvantages of Traditional IRAs
Now consider these disadvantages of traditional IRAs:
Your distributions are taxed as ordinary income, which is higher than the current long-term capital gains tax rate. That means investments that appreciate, such as stocks, may have more favorable tax treatment in a non-retirement brokerage account or in a Roth IRA.
You have to begin taking required minimum distributions (RMDs) at age 70½, even if you have other income sources and don’t need to spend the money in a traditional IRA.
You’re penalized 10% for taking any early withdrawals. There is an exception made if you use the funds prior to age 59½ for certain expenses, such as your first home, higher education, medical bills, or a tax delinquency.
Advantages of Roth IRAs
Now, here are the advantages of a Roth IRA:
You bypass paying taxes on investments that appreciate in value or pay income. That becomes even more valuable to you if the capital gains tax escalates, which is slated to happen over the next few years.
You can pay taxes now when your tax rate may be relatively low. If you believe that you’ll earn more money during retirement than you do now, paying tax at a lower rate for Roth contributions instead of at a higher future tax rate for traditional IRA withdrawals could make sense. If you’re young or just starting your career, it’s possible that your tax rate is lower now than it will be when you retire.
You can pass the account to your heirs, instead of having to take mandatory distributions during your retirement.
You can withdraw your contributions without penalty at any time, as long as you’ve had the account for five years. However, withdrawing your earnings prematurely does trigger a 10% tax penalty.
You can also participate in a workplace retirement plan without any restrictions.
You’ll have less taxable income during retirement since you’re not taxed when you make withdrawals from a Roth. Having less taxable income may reduce the likelihood that you’ll have to pay taxes on your Social Security benefits.
You can invest more on a post-tax basis than with a traditional IRA on a pre-tax basis. For example, a maximum $5,000 Roth contribution may be equivalent to a traditional contribution of $6,667, assuming a 25% tax rate.
Disadvantages of Roth IRAs
The following are the disadvantages of a Roth IRA:
You don’t get a tax break in the year you make Roth IRA contributions.
Your contributions don’t reduce your taxable income (like they do with a traditional IRA), and that could cause you to miss out on certain tax deductions and credits, such as the earned income tax credit or the student loan interest deduction, that have income thresholds to qualify.
You risk that the taxation rules could possibly change in the future so that tax-free withdrawals are no longer allowed, even though you already paid tax on your upfront contributions.
You’re penalized 10% for taking early withdrawals of earnings. There is an exception made if you use the funds for certain expenses, such as your first home, higher education, medical bills, or a tax delinquency, for instance.
Which Investments Should You Hold in Your IRA?
When you’re trying to decide what investments to hold in your IRA, those that could potentially cost you the most in taxes are the best choices, like a dividend stock or a bond income fund. The taxes on the annual income will be deferred with a traditional IRA or eliminated with a Roth IRA. More tax-efficient investments, like a tax-free bond, should be owned in a non-retirement account.
More IRA Investment Tips
A major factor in the question about whether you should choose a traditional or a Roth IRA depends on what the income tax rates will be in the future and how much money you’ll make during retirement. I know; it’s impossible to predict what’s going to happen with government regulations and your income 10, 20, 30, or 40 years from now—so you simply have to take your best guess about it.
If you prefer to have a “bird in the hand” and save money on taxes sooner rather than later, then the traditional IRA should appeal to you. But if you don’t mind paying taxes in the current year, then the Roth has many advantages. And if you’re still undecided, why not split your investments into both types of IRAs? To see how your investments would fare in each type of IRA, plug some numbers into the Roth vs. Traditional IRA Calculator at dinkytown.com.
And a final quick and dirty tip is that if your employer matches your 401(k) contributions, you should always contribute enough to max out your workplace match, before you contribute to an IRA.
Next week we'll look at some more differences between Traditional and Roth 401(k)s. If you're thinking about converting from one Roth plan to another, please read my Quick Tip on how Roth conversions are taxed.
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