Investing for your retirement is one of the most important things you can do for your future. And one of the best ways to do that is by investing in an Individual Retirement Account (IRA). There are two main types of IRAs which most people are eligible to contribute to – the Traditional IRA and the Roth IRA. They have the same contribution limits, but other than that, they are two very different retirement plans. Which is better?
What You Need to Know About Traditional IRAs
Simplified Definition: A Traditional IRA is a tax deferred retirement vehicle. Contributions to a Traditional IRA plan may be tax deductible depending on the taxpayer’s income, tax filing status and other factors. Contributions to Traditional IRAs are made on a pre-tax basis, meaning the money is invested before it is taxed.
The benefit to investing pre-tax money is that it has the potential to lower your current tax bracket, and your money can grow tax free until you withdraw it. Qualified withdrawals are treated as ordinary income and may be subjected to income tax.
Traditional IRA Income limits:
Everyone is eligible to contribute to a Traditional IRA, but not everyone will get the benefit of a tax deduction. Here is a list of the Traditional IRA deductibility limits (2017 limits listed).
- Single, Head of Household, or Married Filing Separately can deduct the full amount of their contribution their MAGI is $62,000 or less. Deduction rates phase out beginning at a MAGI above $62,001, and end at $72,000 (up from $61,000, and $71,000, respectively in 2016). There is no tax deduction for those who have an income higher than $72,000.
- Married Filing Jointly can make maximum Roth IRA contributions for an income of $99,000 or less. Roth IRA eligibility ends at $119,000. (up from $98,000 and $118,000, respectively in 2016). There is no deduction for taxpayers who have an AGI of greater than $119,000.
Traditional IRA Withdrawals:
Traditional IRA holders are eligible to withdraw from their IRA at age 59½, at which point their withdrawals are taxed as ordinary income. There are stiff penalties for early withdrawal (with certain exceptions).
Required Minimum Distributions:
Owners of Traditional IRAs are subjected to Required Minimum Distributions, which begin at age 70½. This means Traditional IRA holders are required to make a minimum withdrawal every year regardless of whether or not they need the money.
Advantages of a Traditional IRA:
There are several advantages for investing in a Traditional IRA, and they primarily deal with taxes. The tax savings at the time of investment may be enough to decrease your taxable income to a lower tax bracket. Many retiree’s income is lower in retirement years, thus they may have a lower tax rate when they withdraw their funds. Depending on your income, you may be able to use a Traditional IRA to lower your tax bracket during your working years, and then withdraw your money in retirement in a low tax bracket.
Disadvantages of a Traditional IRA:
The minimum required distribution is a disadvantage because it requires IRA holders to withdraw a certain portion of their funds – whether they want to or not. It is also difficult to determine what your tax rate will be in retirement.
What You Need to Know About Roth IRAs
Simplified Definition: A Roth IRA is a tax exempt retirement vehicle. Contributions to Roth IRAs are not tax deductible when they are made; however, qualified distributions made during retirement years are tax free.
Roth IRA Income limits:
Roth IRA eligibility is limited based on your Modified Adjusted Gross Income (MAGI). Here are the limits for 2017:
- Single, Head of Household, or Married Filing Separately can contribute the maximum if their MAGI is $118,000 or less. Contribution rates phase out beginning at a MAGI above $118,001, and end at $133,000 (up from $117,000, and $132,000, respectively in 2016).
- Married Filing Jointly can make maximum Roth IRA contributions for an income of $186,000 or less. Roth IRA eligibility ends at $196,000. (up from $184,000 and $194,000, respectively in 2016).
Roth IRA Withdrawals:
The minimum withdrawal age is 59½. When the money is withdrawn, none of it is taxed. The principal can also be withdrawn at any time without penalty, however, the earnings must remain in the IRA or they will be subject to taxes and penalties if withdrawn early. There are other rules that allow Roth IRA account owners to make withdrawals of the principal when certain criteria are met, or make withdrawals for expenses such as college or as a first-time home buyer.
Be certain you understand Roth IRA withdrawal rules before making a withdrawal because making a mistake can be extremely expensive if you end up owing penalties or fees.
It’s also a good idea to make sure early withdrawals won’t hurt your retirement chances. So be sure to research all options before pulling from your retirement account. Learn more about Roth Ira withdrawal rules here!
Required Minimum Distributions:
There is no Required Minimum Distribution for Roth IRA accounts. But there can be RMDs for Roth 401k plans and similar Roth retirement accounts. Be sure to understand the rules regarding your other retirement accounts. One common planning strategy is to roll Roth 401k funds into a Roth IRA at retirement to avoid the RMD requirement. As always, consult a financial planner or tax professional to make sure this is a good idea for your situation, and to avoid making any costly mistakes.
Advantages of a Roth IRA:
The biggest advantage of a Roth IRA is tax free withdrawals on the principal and all earnings. The other advantage is the absence of minimum withdrawal requirements.
Disadvantages of a Roth IRA:
Not everyone qualifies for a Roth IRA because of the income limits. It is possible, however, to do a Roth IRA Conversion, which allows people to convert their Traditional IRA or other retirement fund into a Roth IRA. There are rules with Roth IRA Conversions, and the downside is you have to pay taxes on the amount you convert into a Roth IRA (unless you are converting from a non-deductible Traditional IRA). The tax rules can get a little involved, so it’s best to consult with a tax professional or read the full details before converting to a Roth IRA.
Which IRA is Better – Traditional or Roth?
Investing with IRAs is a great way to diversify your taxes in retirement years, and as you can see, there are distinct advantages to each type of IRA. If you are like me and have the option of funding a company 401(k) plan or other tax deferred retirement plan, then a Roth IRA may be the way to go. This gives me investments that benefit me now by decreasing my taxable income with my 401(k) contributions, but also investing in a Roth IRA, which will give me tax free withdrawals in retirement. It is very difficult (or impossible) to predict our future tax brackets, so tax diversification is a strong benefit to retirement planning.
Where to Open a Traditional or Roth IRA
You can open an IRA in a variety of places, including banks, credit unions, brokerage firms, with an independent financial advisor, and more. In general, I believe it’s best to stick with a financial institution that focuses on investing, as many IRA accounts offered by banks focus on Certificates of Deposit, or have funds with high fees. In general, you will have more investment options with financial institutions that offer full investment services. We have a list of preferred locations to open an IRA.
I recommend investigating your personal situation and investing in whichever plan you decide is best for you. If you are eligible for both, you also have the option of splitting your investment to take advantage of tax benefits now, and in retirement.