When you retire and start drawing money from your investment accounts, do you anticipate that your tax rate will be higher than it is right now? If you answered “yes,” consider choosing a Roth IRA. In the future you’ll likely be moving to a higher rung of the income ladder, and since withdrawals from a Roth IRA are tax-free, your future flush self won’t owe the IRS when you start drawing income.
Roth vs Traditional: How Should You Choose?
If you answered “no,” a traditional IRA may be a better choice. High earners tend to migrate to lower tax brackets upon retirement, so can it make sense for them to take the up-front tax deduction these accounts offer during their working years — and absorb the income tax hit down the road in retirement when their tax rate is lower.
Have no idea how your future tax rate will compare to your current one? Consider splitting the difference: Contribute to both a traditional IRA and a Roth IRA in the same year, which the IRS allows as long as the total amount you sock away is within allowable limits.
How Can I Get Started?
As long as we’re on a roll, let’s address two final obstacles that keep savers on the sidelines instead of jumping in and reaping the major benefits of setting up an IRA:
- See if you earn too much money (in the IRS’s opinion): Your income is the key factor in determining:
- a) if you’re eligible to contribute to a Roth (partially, fully or at all); and
- b) how much of your contribution to a traditional (or regular) IRA you’re allowed to deduct from this year’s taxes.
- Decide where to open an account: The best way to narrow the vast field of contenders is based on how hands-on you want to be: DIY types who prefer to manage the investments on their own should focus on discount brokerage firms. Here’s who we deemed top IRA providers for 2018 based on our research.
If you’re more comfortable with an automated service that determines the best investment mix for you based on your goals, then consider a robo-advisor.
Still unsure? 4 More Key Differences:
That hits most of the high points of how Roth and traditional IRAs work and which one best fits your needs. But beyond the abridged Roth-versus-traditional-IRA discussion, here are deeper dives on the four key ways these accounts differ from each other:
- contribution limits,
- early withdrawal rules and
- required minimum distributions.
Taxes and the Two
The biggest difference between a Roth and a traditional IRA is how and when you get a tax break:
- The tax advantage of a traditional IRA is that your contributions are tax-deductible.
- The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.
In other words, with a traditional IRA, you pay taxes when you take distributions in retirement (or if you make withdrawals prior to retirement).
A Roth IRA operates in reverse: You pay taxes upfront, because your contributions are not deductible. Earnings on your investments grow tax-free in a Roth and tax-deferred in a traditional IRA.
Both traditional and Roth IRA’s come with eligibility rules and restrictions that determine how much you can contribute. Assuming you’re eligible for both, you can contribute to a traditional and a Roth IRA during the same year, as long as the total amount does not exceed the maximum allowable contribution limit of $5,500, or $6,500 if you’re age 50 and over.
The amount you’re allowed to contribute to a Roth IRA, however, isn’t an all-or-nothing scenario — it’s a “heck, yeah!” “sorta” and “sorry, not this year, cowboy” scenario.
Roth contribution limits are based on household income, and those at higher incomes often find themselves squeezed out of Roth eligibility either partially or completely. (See our Roth IRA Contribution Limits page for details on how much your income will allow you to contribute.)
There are no income restrictions for contributing to a traditional IRA’s — titans of industry and everyday workers alike are eligible to open and contribute up to the annual limit — but your income can affect how much of your IRA contribution you’re allowed to deduct from your taxes.
In addition to the size of your paycheck, traditional IRA deductibility takes into account tax filing status and whether you and/or your spouse are covered by an employer’s retirement plan. For details on how this is calculated, see our page on Traditional IRA Contribution Limits.
It’s generally not a good idea to withdraw money from an IRA early, and the rules do a good job of deterring it: You must be at least age 59½ to avoid early withdrawal penalties and taxes. But sometimes dipping into your retirement savings is unavoidable.
When you take money out of a traditional IRA before retirement, the IRS socks you with a hefty 10% early-withdrawal penalty and taxes the money you take out as income at your current tax rate.
The Roth has better terms for those who break the seal on the retirement savings cookie jar: It allows you to withdraw contributions — money you put into the account — at any time without having to pay income taxes or an early withdrawal penalty.
However, there are different rules when it comes to accessing the earnings from your Roth IRA: That money is subject to the five-year rule that states that any earnings withdrawn before your first Roth IRA contribution is at least 5 years old may be subject to income taxes and a 10% early withdrawal penalty.
Fast-forward to your 70th birthday. Six months after you blow out the birthday candles you’ll be subject to required minimum distributions (RMD’s) from your traditional IRA. Remember, the IRS is still waiting to tax that money it has left alone for so long. Taking RMD’s is not a big deal if you’re retired at age 70½ and are already living off your retirement savings.
But if you’re a financially flush member of the silver-haired set who doesn’t necessarily need to withdraw funds from the IRA, the requirement is less appealing. Not only will you have to interrupt the growth of what’s in your account by making withdrawals, but if you’re still working and want to contribute more to a traditional IRA, you’re out of luck. No additional contributions are allowed after age 70½.
For those who live long and continue to prosper, the Roth is less stringent: It has no required minimum distribution rules. You’re free to let your savings stay put in the account and continue to grow tax-free as long as you live.
You’re also allowed to continue contributing to a Roth past the age of 70½. If you’re fortunate enough to not need to tap into the account for income right away and you want to pass on a larger account to your heirs, Roth is the way to go.
When a Traditional IRA Makes More Sense
When you have no other retirement plan — If you have no other retirement plan, then your contributions to a traditional IRA will be fully tax deductible, regardless of income. This is especially beneficial if you are in the higher income tax brackets — say, 24% or higher.
When the IRA is tax deductible, even if you’re covered by another plan — Even if you’re covered by another retirement plan, you can still deduct a traditional IRA contribution if your income does not exceed certain limits. For 2018, singles can earn up to $63,000 per year and still deduct the full amount of the contribution. The deduction phases out between $63,000 and $73,000, after which none of it will be deductible.
If you’re married filing jointly, you can earn up to $101,000 and still deduct the full amount of the contribution. The deduction phases out between $101,000 and $121,000, after which none of it will be deductible.
When your income exceeds the limits for a Roth IRA — With a traditional IRA, you can make a nondeductible contribution even if your income exceeds the income limits. But when it comes to a Roth IRA, once you reach the income limits, you can’t make a Roth contribution at all.
In that situation, it makes sense to make a nondeductible contribution to a traditional IRA. It will increase your retirement funding overall and still allow your investment income to accumulate on a tax-deferred basis.
When a Roth IRA Makes More Sense
When you’re interested in creating tax diversification within your retirement plans — Traditional IRA’s are tax-deferred with respect to both contributions and accumulated investment earnings. Roth IRA’s, however, are tax free if you are at least 59½ at the time you make the withdrawals and the plan has been in existence for at least five years.
In this way Roth IRA’s provide you with income tax diversification. While distributions from other retirement plans become taxable upon withdrawal, your Roth IRA funds come to you completely free from federal income taxes. It’s an excellent strategy, especially if you will continue to be in a relatively high marginal income tax bracket in retirement.
When you want to preserve your money past age 70½ — We’re talking again about required minimum distributions (RMDs) here. They kick in at age 70½, and they apply to virtually every retirement plan except for the Roth IRA. Simply put, once you reach that age, you’re required to begin taking distributions based on your remaining life expectancy.
Since Roth IRA’s have no RMD’s, you can build your investment virtually for the rest of your life. This is an excellent way to continue accumulating retirement assets so that you don’t outlive your money. The Roth has better terms for those who break the seal on the retirement savings cookie jar: It allows you to withdraw contributions — money you put into the account — at any time without having to pay income taxes or an early withdrawal penalty. It’s also an excellent way of preserving more of your estate to pass on to your heirs. Only a Roth IRA can do that for you.
If your income tax liability is either low or nonexistent — Even if you can make a deductible traditional IRA contribution, it may not make sense if you have no income tax liability or if you’re in the 10%, 12% or 22% marginal tax rate bracket.
Since Roth IRA money can be withdrawn completely free from income taxes, it is a superior retirement plan to a traditional IRA. The last thing that you should want to do is trade a 10% tax savings now for a potentially higher tax rate on withdrawals in retirement, which is exactly what you’ll do if you make a contribution to a traditional IRA.
If you think you may need access to the money before retirement — Since there is no tax deduction from making a Roth IRA contribution, the amount of the contribution can be withdrawn free from income taxes and penalties, even if the withdrawal happens before you turn 59½. Not so with a traditional IRA if the contributions were tax deductible when made. So if you think you may need the money before retirement, the Roth IRA should be your choice.
A Third Option
Even though they’re both IRA’s they have so many different provisions that how and when you use them will also be different. So before opening a new account or creating a new retirement plan, consider both types and their effects.
If both seem applicable to your potential situation, there is a third option: You can hedge your bets and maintain both a traditional IRA and a Roth IRA. That way, you’ll be prepared for whatever tax situations come your way.
Start by looking at your income. There are income limits for Roth IRA’s, so if your income is above those limits, then it’s a no-brainer: a traditional IRA is the only one for you. Let’s say you’re eligible for both a Roth and a Traditional IRA:
Generally, you’re better off in a traditional if you expect to be in a lower tax bracket when you retire.
By deducting your contributions now, you lower your current tax bill. When you retire and start withdrawing money, you’ll be in a lower tax bracket, thereby giving less money overall to the tax man.
If you expect to be in the same or higher tax bracket when you retire, you may instead want to consider contributing to a Roth IRA, which allows you to get your tax bill settled now rather than later.
But it can be difficult, if not impossible, to guess what tax bracket you will be in later in life, particularly if you’ve got a long way to go until you retire.
So if you’re not sure, another rule of thumb is to keep your retirement savings tax diversified, meaning you have accounts that will be both taxable and tax-free when you cash out in retirement.
For example, if you already have a tax-deferred 401(k) plan through your employer, you might want to invest in a Roth IRA if you are eligible.
The Roth also offers more flexibility: You can withdraw your contributions (but not the earnings) without incurring a penalty so you have more access to your money. When you take money out of a traditional IRA before retirement, the IRS socks you with a hefty 10% early-withdrawal penalty and taxes the money you take out as income at your current tax rate. So if you’ve got a long way to go before retirement, and you’re concerned about locking away your money for too long and want to be able to get at it if you need it, a Roth might be the way to go.
You can rollover either a Roth or a Traditional IRA to a Gold SDIRA (self-directed individual retirement account) consisting of physical gold and other precious metals coins and bullion. If that is what you wish to do, we recommend viewing our page on Best Gold IRA Options.
Do you have any further questions on whether you should choose a Traditional or Roth IRA? Ask below!