Traditional vs Roth IRAs – Which Should I Choose?

Does Thinking About Retirement Accounts Traditionally Fill You with Wroth?

 

If so, you’re not alone.  Between all the different rules and regulations, minimum distribution requirements and tax treatment, there are a lot of things that go into making the different kinds of retirement accounts distinct from one another.  Let’s start off by saying that having any kind of retirement account that you contribute to is better than having no retirement account, but then deciding which one is best for your situation is a bit more involved.  Here are a few things to consider when deciding what type of account to open.  Do note that this article is focusing only on Individual Retirement Accounts (IRAs), I will discuss other types of accounts later.

Who Should Open One?

Before discussing the individual pros and cons, let’s address who should open a retirement account in the first place.  They’re not for just anyone to have, right?  Wrong.

Anyone who does not have an employer-sponsored 401k/403b plan, and who earns taxable income individually or jointly with their partner, should STRONGLY consider starting an IRA and making regular contributions to it.  IRAs are designed to give tax advantages and incentives to invest and grow your money for retirement.  In exchange for these tax breaks, these accounts come with the warning label “DO NOT OPEN UNTIL RETIREMENT (Significant penalty for early withdrawal…)”  You can think of these accounts like a bank vault with a time lock; there is a slot to deposit money, and you can tell the bank what to do with the money.  But if you make them open the vault so you can get the money out before you hit retirement age, they are going to charge you at least 10% of what you take out.

You are allowed to contribute a maximum of $5,500 per year to all IRAs, meaning that the combined total between all of your IRA contributions must be equal to or less than $5,500 ($6,500 if you are 50 or older).  Also note that while there are no income limits on who can contribute to a traditional IRA, people wishing to invest in a Roth must abide by income guidelines.  For 2017, the phase-out for Roth contributions starts at $118,000 and culminates with the taxpayer being ineligible to make a Roth contribution if they earn $133,000 or more (if filing jointly, the numbers are $186,000 and $196,000 respectively).

Tax Treatment

This is one of the principal ways of distinguishing between a Traditional and a Roth IRA.  They are treated slightly differently because they are funded slightly differently.  With a Traditional IRA, the account is funded using pre-tax money.  Even though you might have technically received it as income, by earmarking it as a contribution to a Traditional IRA, your taxable income for the year will be adjusted down commensurate to the amount you are contributing.  Since governments survive off taxes, however, you can’t get away with never paying taxes on the money you are saving for retirement.  When the money is eventually distributed, the funds will be taxed as ordinary income.

Roth accounts, on the other hand, have the reverse effect.  When you contribute money to a Roth, you are doing so with after-tax dollars.  There is no income tax benefit for the year in which you make contributions.  The corollary to this is that because you have already paid taxes on these contributions, the money within the account grows tax-free.  As long as you follow the guidelines for Roth accounts, such as waiting until you are 59 ½ years old and the account is older than 5 years, you will not owe taxes on distributions from this account.

When to Contribute/Distribute

Another aspect to keep in mind is the age-based differences between the two types of accounts.  When it comes to Traditional IRAs, there are a number of things to consider.  These accounts can only be opened if you are under the age of 70 ½, and once you reach 70 you are required to start taking minimum distributions from the account, with that amount based on your age (the older you are, the greater the percentage of the account you must distribute).  These Required Minimum Distributions (RMDs), and any other amounts taken out of the account, are taxed as ordinary income.

Roth accounts are more flexible when it comes to the age of the investor; you can open one regardless of age, and there is no age at which distributions are mandatory.  You also have more flexibility in what you can use the money for outside of retirement, as you are allowed to withdraw your contributions without paying a penalty, seeing as you have already paid taxes on the contributed amount.  If you touch any part of the gains, however, you will have to pay taxes and a 10% penalty unless the funds were used for certain exemptions (such as a down payment for your first home, or helping to fund your kid’s college.)

So Which Account Should I Get?

There are pros and cons to each type of account, but it is the tax treatment that makes up the main decision point between these types of retirement accounts.  Traditional IRSs are a good way to get some tax benefits in the short term, in exchange for the uncertainty of your tax situation in the future, both in terms of your income bracket and the going federal/state tax rates.  Roth IRAs are a good way to build up a retirement account and not have to worry about what the tax situation will be like in the future, because you already paid them on the money.

In short, Traditional IRAs are best when you are confident your tax bracket in retirement will be less than your current bracket, and Roth IRAs are best when you believe your tax bracket will be higher when you retire than it is currently.  If you still are not sure what the best option is, or would like a second opinion, consider speaking with a CPA or financial advisor.

Matthew Vitlin is a Fee-Only financial advisor with Reliant Wealth Management. He helps individuals and families from all walks of life start, grow and manage long-term investment portfolios.

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