Many of us all but ignore our retirement accounts for much of our working lives. We look at a pay stub and have a vague sense of the “minuses:” Social Security, insurance, taxes. But the IRA is one of the most powerful retirement savings tools available to us, and so it warrants our attention.
Its variant, the Roth, also offers dynamic savings opportunities, and which one of these works for you depends on your financial plan and a variety of other factors.
Let’s look at the basics of the traditional versus Roth IRA to see which one might work best for your wealth journey. The differences range from glaring to subtle, and the more intentional you are about the choice, the more you can end up saving in the long run.
The Basics
First, let’s define terms. The IRA, or individual retirement account, was created by the U.S. government to encourage saving for retirement and curb financial distress among retired individuals. Because they are intended for retirement, you’ll get penalized in most cases for accessing the funds before age 59.5.
Both the Roth and traditional IRA have a contribution limit of $6,000 per year, with a $1,000 catch-up contribution if you are over age 50 (in 2020-21). The contribution deadline to any kind of IRA typically mirrors the deadline to file your tax return. In most years, you can contribute to your IRA until April 15, for example.
Traditional IRAs were introduced during the Employee Retirement Income Security Act of 1974 (ERISA) and first gained widespread popularity in the 1980s. Roth IRAs were introduced in 1997, named for Senator William Roth. Let’s look at the basic differences between these two versions of the IRA.
How do the Taxes Work?
The most noticeable difference between a traditional versus Roth IRA is the way the taxes work. Contributions to traditional IRAs are made with pre-tax dollars, and growth is tax-deferred. That means the gains are taxed upon withdrawal. So, the taxman knocks, but he knocks later.
If you have a Roth IRA, you pay the taxman upfront, and he essentially never comes knocking. The growth is tax-free and withdrawals in retirement are almost always tax-free. You’ve basically done your tax work upfront, so the IRS doesn’t care how much it grows – it’s your money at that point.
Generally, those who are in a high tax bracket today typically benefit more from a traditional IRA than those in a lower tax bracket. And those who are in a low tax bracket today typically benefit more from a Roth IRA than those in a higher tax bracket.
Two Plans, Two Scenarios
Let’s look at two scenarios in which both plans are advantageous for certain reasons. Each financial journey is unique, so a blanket answer – ”always this, never this” – won’t work for IRAs or other financial choices.
Traditional IRA Scenario
In the first scenario, we have an investor in the wealth-building phase who is in the 24% tax bracket and not participating in an employer-sponsored plan. She determines she can put $6,000 into her traditional IRA and reduces her current income from $105,000 to $99,000 saving her $1,440 in taxes.
When she reaches retirement, her taxable income reduces greatly to $30,000 and places her in the lower tax bracket of 12%. At this time she needs additional income and decides to pull it from her traditional IRA. If she were to take a $6,000 distribution, she would pay $720 in taxes. That’s half of what she would have paid on the $6,000 if she decided not to contribute to her traditional IRA.
Roth IRA Scenario
In the second scenario, we have an investor early on in his career. He’s single and on the high end of the 12% tax bracket earning $35,000 a year. He starts a Roth IRA, and contributes the max $6,000, paying $720 in taxes right away.
After a long successful career, he retires and has a fixed income of $75,000 a year, placing him firmly in the 22% tax bracket. In the event he needed additional income, he could take a distribution from his Roth IRA and pay $0 in taxes since he already prepaid his tax bill when he made his contribution.
These are simplified scenarios. Everyone’s situation is unique, and there may be factors other than your tax bracket that could influence which account is right for you.
How do I Get Access to the Money?
As with any financial instrument, there are parameters on access to the funds. Remember, the IRS is trying to encourage saving for retirement, so they don’t want you to take the money early.
Traditional IRA
We’ve already discussed the magical age of 59.5, which applies to all IRAs. If you take your money out before then from a traditional IRA, not only will you pay taxes on the contributions and the growth, but you’ll also pay a 10% early withdrawal penalty tax. That’s essentially akin to jumping a few tax brackets on that money – not a situation you want to be in!
Exceptions
There are exceptions to these penalties. You can possibly take an early withdrawal if you qualify for a hardship distribution. You can also take $10,000 out the first time you build or buy a home, and your spouse can take that distribution as well. These distributions and a handful of others can help you avoid the early withdrawal penalties.
Roth IRA
One of the perks of a Roth is the money is considered yours because it’s after-tax (as long as you take it at the correct age). The IRS has already taken their part of it, so they leave it alone. There are a few catches of course.
5-Year Rule
Although contributions to a Roth are always accessible, you have to wait five years after opening a Roth before you can withdraw your earnings without fees. Keep in mind that this is five years from when you start your first Roth account. You could start an account, wait the five years, start another one and take from those earnings as soon as they arrive.
59.5
Age 59.5 is the magical no-penalty withdrawal age for traditional and Roth IRAs. With a Roth, your earnings on your contributions will be taxed if you withdraw them before this age. So if you deposited $6,000 and it grew to $10,000 and you withdrew that full amount, you’d pay taxes on the $4,000. After age 59.5 there’s no penalty.
Restrictions and Parameters
When the IRS gives you breaks or privileges with a financial vehicle, you can be sure there are restrictions on it as well. We’ve already discussed the contribution limit for both IRA types – $6,000, or $7,000 if you’re over age 50 (for 2020 and 2021).
Restrictions for a Traditional IRA
There are no income limits to be able to contribute to a traditional IRA, but your tax deductions run into limits if you or your spouse are covered by a 401(k) at work. For 2020-21, if you make over $66,000 a year (MAGI), you start to reach the phaseout and will only receive a partial deduction for contributions. After your income reaches $76,000, you will no longer receive any tax deduction. For married filing jointly, phaseout starts at $105,000 and the deduction disappears altogether at $125,000 in income.
Restrictions for a Roth IRA
The incredible financial planning opportunity available with a Roth comes with income restrictions. Essentially, if you make too much money, you can’t start a Roth account. For 2021, you hit the phaseout threshold at $125,000 and the ceiling is $140,000 for a single person. For married filing jointly, the phaseout starts at $198,000 and ends at $208,000.
There are strategies such as the Roth conversion and the backdoor Roth conversion to work creatively with Roth limitations.
Powerful Tools in the Right Hands
As you can see, the IRA is a powerful savings vehicle for retirement and can put your money to work for you rather than gathering only dust in the bank. Whether you go with traditional versus a Roth IRA is a matter of weighing the details against your life.
Talk with your financial advisor about what works for your place in the wealth journey and your particular dreams for retirement – there’s no generic answer to that question. The important thing is to get started!
Get in touch today, and let’s see what works for you!
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reach age 59 ½, may be subject to an additional 10% IRA tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.