Part 1: Traditional vs Roth IRA
As a trusted financial advisor in Carlisle, PA, people often ask me the question, “Which retirement account is better, Roth or Traditional?” The answer is; it depends.
It depends on your current tax versus future tax situations, longevity concerns, estate considerations, and account diversification. Whether you are thinking of contributing to an IRA or your 401K/4013b, there are many factors to consider before deciding if pre-tax or after-tax contributions make sense for you.
In this article, we discuss the pros and cons of each type of retirement account and how it may benefit your financial situation. First, let us start with the similarities.
Traditional or Roth, which is better?
Both retirement savings accounts let you invest in a variety of investments from stocks, bonds, mutual funds, ETFs, and cash. As long as the money remains in the accounts the earnings are not taxed for both accounts. Additionally, both retirement accounts have the same contribution limits if you are eligible. The limits for 2021 for IRAs are $6,000 for everyone under 50 and $7,000 for those over 50. For 401ks, the personal contribution limit is $19,500 under 50 and $26,000 over 50. The biggest difference between a Roth IRA and a traditional is how and when you get a tax break. Let us discuss the pros and cons of each
Traditional IRA- Tax me later.
Immediate tax benefit- Contributions to traditional IRAs are tax-deductible and reduce taxable income in the year that they are made. The pre-taxed option of a traditional IRA can be attractive for investors and savers because you get the tax break immediately. This is an ideal scenario if you are in a higher tax bracket now and expect to be in a lower tax bracket in retirement. For most people, this logic seems to make sense as you no longer are bringing in as much money in retirement and are in a lower tax bracket.
Phase-out of deductibility- The IRS has eligibility rules for traditional IRA deductibility, and it is important to check those before deciding to contribute. For 401ks and other employer sponsored plans, the eligibility falls within the plan and the employer (number of hours worked, etc.). Eligibility for IRAs can be found on the IRS website.
Required Minimum Distributions- When you reach age 72, the IRS forces you to start taking money out of your account. These withdrawals are called Required Minimum Distributions and are based on a life expectancy table. You are required to take the money out and pay taxes or pay a hefty penalty, even if you do not need the money each year.
Taxable withdrawals- Traditional IRA withdrawals will always be taxed as ordinary income rates. That means you are subject to federal and state tax levels and a 10% penalty if withdrawn before age 59 ½. There are some exceptions to the 10% penalty rule if the funds are used before 59 ½ for qualified expenses. Click here to view the rules for a penalty exemption.
The Roth: Tax me now and never again, please.
Tax free growth and withdrawals- One of the greatest retirement account benefits in the entire tax code is the Roth IRA and the ability to grow a tax-free stream of income in retirement. Contributions to Roth IRAs are not tax-deductible now, but the withdrawals in retirement are tax-free.
State taxes- Another common question I get is, “Are Roth IRAs free from state tax?” Yes, that is another important factor to consider. Particularly if you are working in one state that has no or low state tax and then retire to a state that has higher state income tax resulting in your total potential tax liability being higher than you may have anticipated.
More flexible withdrawal options pre 59 ½- The 10% penalty on withdrawals pre 59 ½ only applies to the earnings in an account. That means that ALL contributions made into a Roth can be withdrawn tax and penalty free. This gives savers more flexibility in the event they want to tap into those funds early. The penalty is also waived for the same exemptions as the traditional IRA.
No Required Distributions- One important distinction about Roth IRAs is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. This is a benefit to the Roth because the money can continue to grow over time, in a tax-sheltered account, without having to be withdrawn and taxed like the traditional IRA. It is important to note that if the account owner dies then the beneficiary is now subject to RMDs. So, longevity is a factor to consider.
Remove the unknown tax variable- You know what your tax rate is now, we do not know what it will be in 5,20, or 30 years from now. Do you think tax rates are going up? You may be in a higher bracket in the future. Here is another scenario: If you are a Federal Employee and receiving your FERS pension and social security and have accumulated assets in your TSP, your withdrawals in retirement may put you in a higher tax bracket than you experienced while working. Removing that tax variable from the planning process means not having to worry about the potential tax drag in the future.
No immediate tax benefit for contributing- This again depends on your situation and your current versus future tax liabilities.
Phase out contributions- You can always contribute to a traditional IRA even if those contributions are not tax deductible, however with a Roth IRA, you cannot always contribute and may be subject to excess contributions and penalties if you make too much money in a year and contribute. It is important to pay attention to the IRS rules for eligibility. Here is a link to the current Roth eligibility limits.
At the end of the day, avoiding lifetime RMDs, having more flexibility with contributions, and removing the tax variable in retirement might be enough to sway many investors into a Roth. I like to preach diversification. Similar to diversifying investments across different asset classes to reduce risks and the unknown, it makes sense to practice tax diversification. The reality that tax liability has an impact on real wealth creation simply cannot be ignored. Splitting contributions between Roth and Traditional can make good financial sense. If you are unable to start a Roth or are not sure how to boost your tax-free accounts, a Roth conversion might also help you to accomplish your goals.
Part II of this Blog we will explore Roth conversions and how they can supercharge your tax-free accounts in retirement.
Sources: IRS. https://www.irs.gov/retirement-plans