Since its introduction in 1975, the Individual Retirement Account (IRA) has become an extremely popular vehicle for people wanting to put away money for retirement. And with good reason: IRAs are easy to establish and offer powerful tax benefits.
As an investor, you may have the choice between a “traditional” IRA and a Roth IRA, depending on your income levels. While the traditional and Roth options are similar in some respects, there are several important differences when it comes to how contributions and withdrawals are taxed. So, which IRA should you use?
There may not be a single “right” answer—but you’ll be able to make an informed decision once you’re familiar with both types of IRAs.
Who can contribute?
Your choice between a traditional and Roth IRA may depend not on your preferences, but on your income.
For the 2020 or 2021 tax year, you can contribute up to $6,000 (or $7,000 if you’re 50 or older) to a Roth IRA if your modified adjusted gross income is less than $196,000, if married and filing jointly, or $124,000 if you’re single. Contribution limits start to phase out above those amounts, and you can’t contribute to a Roth IRA at all once your income reaches $206,000, if you’re married and filing jointly, or $139,000, if you’re single.
By contrast, you can generally contribute the full $6,000 (or $7,000 if you’re 50 or older) to a traditional IRA, no matter how much you earn. But your income level may influence how much of your contribution is deductible, as we’ll discuss in more detail below.
Tax-deductible contributions vs. tax-free growth.
In regard to taxes, traditional and Roth IRAs differ substantially, both in the contributions going into the IRA and the earnings resulting from those contributions. Generally speaking, traditional IRAs provide an up-front tax break through tax-deductible contributions, whereas Roth IRAs provide a benefit on the back end in the form of tax-free growth of the investments.
Here’s a more detailed look at the tax implications and other rules for the two types of IRAs:
- Traditional IRAs – When you invest in a traditional IRA, your contributions may be completely tax deductible in the year when you make the contribution. Furthermore, this is an “above-the-line” deduction, meaning you can take advantage of it even if you don’t itemize your tax return. However, the deduction may be limited if you or your spouse are covered by your employer’s retirement plan, such as a 401(k), and your income exceeds certain levels. But whether your contributions are fully or only partially deductible, your IRA’s earnings will grow on a tax-deferred basis.
- When you withdraw money from a traditional IRA, the entire amount of the distribution—your initial contributions and the investments’ growth—is taxed as ordinary income. Also, when you reach age 70 ½, you must start taking required minimum distributions from your traditional IRA. To learn more about this, see our article RMDs: What Retirees Need to Know About Required Minimum Distributions.
- Roth IRAs – Contributions to a Roth IRA are never deductible, but distributions from the account—both the contributions and the growth—are tax-free, provided you’ve had your account at least five years and you don’t start taking withdrawals until you’re at least age 59 ½. Also, since you’re putting after-tax dollars into your Roth IRA, you can withdraw any amounts you’ve contributed at any time, free from taxes or penalties. Another benefit of Roth IRAs is that there are no required minimum distributions, so you can allow the investments to continue growing tax-free throughout your life.
Factors to consider.
Now that we’ve looked at some of the basic properties of traditional and Roth IRAs, let’s consider some factors that could help you determine which IRA is right for you.
- Your tax bracket in retirement – If you knew for sure which tax bracket you would be in during your retirement years, it might not be too difficult to choose the right IRA. For example, if you were confident you’d be in a lower tax bracket during retirement, you might pick a traditional IRA because you’ll benefit from decades’ worth of tax deductions, and once you start withdrawing from your account, the distributions will be taxed at a lower rate than your current rate. Conversely, if you knew you’d be in a higher tax bracket in retirement, you might be better off taking advantage of a Roth IRA’s tax-free growth.
- But as the well-known New York Yankees catcher and philosopher Yogi Berra once said, “It’s hard to make predictions—especially about the future.” Generally speaking, the higher your income during your working years, the greater the probability that you’ll be in a lower tax bracket in retirement—but “probability” isn’t “certainty.” You’d have to compare your current and projected income during your working years with your estimated retirement income, which will come from a variety of sources: Social Security, your 401(k) or other employer-sponsored retirement plan, other retirement accounts, and other savings and investment accounts. You might even have earned income from consulting or part-time work. Another variable you might want to consider is the possibility (or likelihood) that Congress will change the tax brackets between now and your retirement.
- In short, unless you are very sure that your retirement income is going to be significantly different than your income during your working years, you may not want to use taxes as the primary determining factor in which IRA to choose.
- Your future employment plans – If you enjoy what you do, you may not want to call it quits when you reach your mid- to late-60s. With a traditional IRA, you can’t contribute after you turn 70½, even if you’re still working. But with a Roth IRA, you can keep making contributions at any age, as long as you have earned income.
- Your need to tap into your IRA before you retire – When you take money out of a traditional IRA before you reach age 59 ½, the IRS imposes a 10% early-withdrawal penalty and taxes the money you withdraw as income at your current tax rate. But with a Roth IRA, you can withdraw the amounts you’ve contributed at any time, tax- and penalty-free.
- Your need to tap into your IRA after you retire – When you have a traditional IRA, you will need to start taking required minimum distributions once you turn 70 ½. But with a Roth IRA, you’re never forced to take RMDs—you can leave the money untouched for your entire lifetime, if you choose.
- If you think you might have enough financial resources for retirement from other sources, such as your 401(k), pensions, Social Security, and other savings, and you’d like to pass on most, or even all, of your IRA assets to your children or other family members, you might decide a Roth IRA is the right choice.
- Your philanthropic goals – If you would like to make sizable donations to charities during your retirement years, it might be advantageous to choose a traditional IRA. You can transfer your RMDs—up to $100,000 per year—to charitable organizations, which would keep these funds out of your taxable income, possibly even preventing you from moving to a higher tax bracket. This strategy, known as a charitable rollover, may also help you avoid an increase in the amount of Social Security income subject to income tax. (These issues can be complex, so you’ll want to consult with your tax advisor before you transfer your RMDs to charities.)
Not necessarily an ‘either-or’ decision.
The above factors may lead you toward either the traditional or Roth IRA, but you don’t have to commit yourself 100% to one or the other. If you meet the requirements for both IRAs, you can contribute to both in a single year, as long as your total contributions don’t exceed the annual $6,000 or $7,000 limit. Dividing your contributions may be a good way to “hedge” against the uncertainty of whether your tax bracket during retirement will be higher or lower than your current tax bracket.
Even after you’ve chosen a traditional IRA, you aren’t necessarily “stuck” with it forever. You could decide to open a “backdoor” IRA, which lets you roll as much money as you want from an existing traditional IRA to a Roth, even if that amount exceeds the yearly contribution limits. But walking through this back door isn’t free. You must pay taxes on any money that you convert from your traditional IRA that hasn’t already been taxed, and the funds going into your Roth IRA will likely count as income, which could push you into a higher tax bracket that year. So, you’ll have to weigh these costs against the potential long-term benefits of a Roth IRA.
Does the type of IRA affect investment choices?
When thinking about an IRA as part of your overall financial strategy, you’ll need to evaluate the various factors to determine what type of IRA to select. But your choice of IRA may also affect another key IRA component—the investments you’ve picked to fund your account.
For example, if you choose a traditional IRA, which requires you to start taking withdrawals at age 70 ½, you might be inclined to shift your portfolio toward a more conservative position as you approach retirement. But because Roth IRAs don’t have requirement minimum distributions, you effectively have a longer time horizon for these investments, which means you might be able to assume more risk in this account. As you think about your entire retirement portfolio, you may want to put a higher percentage of your riskier, higher-growth-potential investments in a Roth IRA and more of your lower-risk investments in a traditional IRA.
We’ll help you navigate the IRA journey.
It can be challenging to choose the right IRA and to properly manage the investments inside it. Over time, you may need to make changes to your strategy in response to changes in your life’s circumstances. At Leelyn Smith, we’re here to help you navigate all of these decisions and create a strategy for using the right types of retirement accounts for working towards your retirement goals.