You’ve been working hard and earning income for years, hopefully saving a portion of your earnings for retirement.
With most pensions having gone away, retirement savings accounts like an Individual Retirement Account (IRA) are going to be your safeguard or reserve to generate retirement income. The type you choose — whether a Traditional IRA or a Roth IRA — makes a difference.
Taxation of contributions is the main difference between these two IRAs. Traditional IRAs are typically funded with pre-tax contributions, which grow tax-deferred and are then taxed upon distribution in retirement. Roth IRAs are funded with after-tax contributions, which grow tax deferred, and are distributed tax free in retirement. The decision to save taxes now (Traditional) or save taxes later (Roth) is a personal one and based on several factors that we’ll address. But first…
Generally speaking, IRAs have a low annual contribution limit. In 2020, the maximum contribution to either a Traditional or Roth IRA is $6,000. You can have both types and, depending on your income, can even contribute to each, but the combined contribution cannot exceed the $6,000 annual combined limit. If you’re 50 years or older, you can contribute another $1,000 per year as a “catch-up contribution.”
IRAs are good consolidation vehicles. In your working career, you’ll probably change jobs a few times. When you do, those old 401(k) or other workplace retirement accounts can add up, making it hard to keep track of the different statements, let alone investment choices. To simplify, they can be rolled over into a Traditional or Roth IRA so there are fewer accounts to maintain.
You can make a contribution to a Traditional IRA, regardless of your income. However, you can only take an income tax deduction if your income falls below a certain threshold.
*If you do not have a workplace retirement plan, you may be able to deduct a Traditional IRA contribution, even if you exceed the income limits above.
Contributions to a Roth IRA have their own limitations. Because these contributions are made with after-tax dollars, there is not a second way to contribute like the Traditional IRA.
Let’s assume your income provides you choice in which contribution to make. How do you choose? Consider your current tax circumstances and your expected tax bracket in retirement. Will you be in a higher or a lower marginal bracket when you retire than you are now?
If you’re in the prime of your working career and expect to be in a lower tax bracket in retirement, taking the deduction now via a Traditional IRA would be more strategic. Do you currently pay state income tax and plan to retire to a state without one? Again, the Traditional IRA could be the better choice.
Will you have a pension – aside from Social Security – in retirement to help cover your income needs? If so, you may want to consider the Roth IRA because Traditional IRAs are subject to Required Minimum Distributions (RMD) starting at age 72. Even if you don’t need the money, the government wants to start collecting taxes on those deferred funds. Since Roth accounts have tax-free distributions, they aren’t subject to these RMD and make for a good pairing with taxable pension income.
Much like the benefits of investment diversification within your accounts, diversity in IRA types can give you tax options. You can be strategic by utilizing both Traditional and Roth IRAs to give you more control over the taxes you pay in retirement.
Both types of IRAs are transferable to future generations, but recent legislative changes have made Roth IRAs especially desirable. In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which made significant changes to inherited IRA distributions, including the elimination of the Stretch IRA (with limited exceptions).
Now, individuals who inherit an IRA must fully distribute the account within 10 years. A large, inherited pre-tax account may not only incur significant federal and state tax liabilities, but may cause an individual or family to be phased out of certain tax deductions like education credits, student loan interest deductions or the ability to contribute to Roth IRAs.
IRAs are wonderful retirement planning tools, but deciding which one is right for you depends on your current and post-retirement financial situation. Each option has its own advantages, but ultimately, the choice depends on the most advantageous time to pay taxes on your investment.
If you want to get a tax deduction now, choose a Traditional IRA and pay taxes later. If you don’t mind missing out on the initial tax deduction, choose a Roth IRA and make tax-free withdrawals in retirement. Or, choose both IRAs to make the most of your options.
Need help with a Traditional IRA, Roth IRA or retirement planning? Please reach out to us to get started.