When it comes to investing, one size does not fit all. This is especially the case when it comes to deciding whether to go with a traditional or Roth IRA. Depending on your situation, either one could provide certain tax advantages to your financial plan. But you need to know the key differences.
The Basics of Traditional and Roth IRAs
Individual Retirement Accounts are vehicles that offer tax-advantaged investing, and they can be beneficial for accumulating funds earmarked for retirement. They are fairly easy to establish and may have a particular appeal to those who do not have access to a retirement plan at work.
For both types of IRAs, the 2015 maximum annual contribution limit is $5,500 ($6,500 if you are age 50 or over), and cannot be more than your taxable income for the year. Prior year IRA contributions can be made until April 15th of the following year. Contributions cannot be made to your traditional IRA for the year in which you reach age 70½ or any year thereafter. Roth IRAs do not have this limitation. Contributions can be made even after you reach age 70½ and may remain in the Roth IRA for as long as you live.
Your traditional IRA contributions may be tax-deductible, but the deduction is subject to certain income limitations if either you or your spouse is covered by an employer sponsored plan. For a Roth IRA the contributions are not deductible, but the maximum contribution amount might be limited based on your tax filing status and income. For more information, IRS Publication 590-A offers detail into these deductions and limitations.
Tax Now or Tax Later: Deciding Your IRA Strategy
Roth IRA contributions are made with after-tax dollars and enjoy the benefit of growing tax free. Once you have reached age 59½ and have had your IRA for 5 or more years you may begin taking qualified, tax free distributions from your Roth IRA. Conversely, a traditional IRA is funded with pre-tax dollars and the assets grow tax-deferred. Eventually the funds are required to be distributed and are included in your tax filing as taxable income. The essential difference here is that contributions to a traditional IRA may provide a tax benefit at the time they are made, whereas Roth IRA contributions go without tax deductions in exchange for a reduced tax burden in the future.
There isn’t a right answer as to which type of IRA is better. The choice you make will depend on your own priorities and situation with regard to your tax filing status, income, and employment. If you expect to be in a lower tax bracket when you retire, contributing to a traditional IRA could be a useful strategy, as future withdrawals will be taxed at a lower rate. By contrast, if you can handle paying the taxes upfront while you are still working, the Roth IRA vehicle will provide you with more cash at retirement because of tax free withdrawals.
Something Else to Consider: Withdrawals
There are also significant differences that determine when you are allowed to withdraw your IRA funds and potential early withdrawal penalties.
- Traditional: You must begin taking required minimum distributions once you reach age 70½.
- Roth: You are not required to take any distributions.
- Traditional: Early withdrawals are taxed and incur a 10% penalty if you are below age 59½. There are exceptions to avoiding the early withdrawal penalty for qualifying events such as first home purchases, qualified higher education expenses, and some medical expenses.
- Roth: The rules covering early withdrawals of Roth IRAs are a lot more complicated. If you take a distribution that is not qualified (for example, you’re under 59½, or you’ve held the account less than 5 years), you will incur the 10% early withdrawal penalty, but only a part of the distribution may be taxable, depending on whether contributions or earnings are being withdrawn.
You may not be sure if you are going to be in a higher or a lower income bracket in 10, 20, or 30 years, as life is full of uncertainty. You also don’t know what those tax brackets will look like many years from now. If you truly need that tax deduction now (and you qualify for it), and you think you’ll be comfortable paying income tax on those deferred savings down the road, the traditional IRA may work well. You’ll still get the benefit of tax deferral on your investment gains, dividends, and interest generated within the account.
The Roth IRA provides a vehicle for setting aside funds that will grow and distribute funds on a tax-free basis for the rest of your life. This may appeal to people who expect to be in a fairly high tax bracket during their later years.
Building and funding a diverse investment portfolio is generally a good strategy to help fund your retirement needs. Incorporating IRA accounts adds a layer of tax benefit to that process, which can further improve your retirement planning.