This post is part 1 of a series on traditional IRAs and Roth IRAs. While this post may be a bit basic for some readers, especially those who have a working knowledge of the major types of retirement plan vehicles, I thought it would be important to include it as an introduction to some of the more in-depth discussions to be addressed later.
Whether or not your employer has a retirement plan, you can contribute to an Individual Retirement Account (IRA) on your own. It’s a nice way to get your retirement investing started, or to supplement your other sources of retirement income, and depending on the type of IRA you choose, it can be a really great way to give yourself taxable income flexibility in your later years. But if you’re having difficulty choosing between a Roth IRA and a Regular IRA, here are some considerations that might help you make your decision.
The Primary Difference Between a Roth IRA and a Traditional IRA is When the Money is Taxed
There are some other differences, too, but let’s focus on the big one first.
Contributions to a Roth IRA are not tax-deductible when they are made. Said another way, Roth IRA contributions are made using after-tax dollars. But because those contributions are taxed on the front-end, all of the withdrawals from the Roth IRA during retirement, including all income earned on the account, are completely tax-free.
With a traditional IRA, the taxation scheme is reversed. Contributions to a traditional IRA are tax-deductible when made, so you get a tax advantage now. Those contributions grow tax-free as well. But the tax man comes to collect when you start taking withdrawals, and the withdrawals are taxed as ordinary income.
So the tricky question for many people is: which is better for me? A traditional IRA or a Roth IRA? The answer, of course, is that it depends. Here are some factors to take into consideration:
What is your effective tax rate now, and what do you expect it to be at retirement? If it’s low now and you expect it to go up, then a Roth IRA is probably right for you.
If your effective tax rate is currently low, say 15%, but you are young and motivated, and you fully expect to be earning in the top tax brackets in retirement, then a Roth IRA is probably a great choice for you. The non-deductible IRA contribution shouldn’t bother you much, since your tax deduction would be a very small 15% in your current tax bracket, and getting your money tax-free in retirement might save you quite a bit if you are in the higher tax brackets then.
On the other hand, if you’re in a high tax bracket now, but you expect to be in a low income tax bracket upon retirement, then you might be better off with a traditional IRA. Alternatively, if you think the tax rates are very high now in general and are likely to decrease by the time you retire, then you might be better off with a traditional IRA. You will get a good tax benefit now for your contributions, and you’re likely to be no worse off by taking the tax hit when you retire.
Are you going to need the money when you’re 70, or do you want it to sit and grow longer?
Traditional IRAs have Required Minimum Distributions (RMDs) that force you to start withdrawing some of your IRA when you turn 70 1/2. If you think you’re going to have plenty of income when you retire, and you’d really like to keep your money sitting in your IRA rather than withdrawing it and having to pay tax on the withdrawals, then a Roth IRA might be better for you. Roth IRAs have no RMDs, and you can even keep contributing to an IRA in your 70s, so long as you have earned income to contribute.
Do you want to pass along the benefits to your beneficiaries tax-free?
Because Roth IRA withdrawals are not taxable, when you die, you can pass your Roth IRA to your beneficiaries, and they will be able to withdraw the proceeds tax-free. This can be especially helpful if you’re leaving your IRA proceeds to a beneficiary who is in a high tax bracket.
Do you already have a 401(k), Traditional IRA, or other income source in retirement?
If you have other sources of income in retirement, and you want your IRA income to be the icing on the cake, then you might want to contribute to a Roth IRA. Having a mix of taxable and non-taxable income in retirement is a great way to give yourself some income tax flexibility. If your income from other sources is pushing you close to the next-higher tax bracket, you can withdraw more income from your Roth IRA and less income from your taxable IRA or 401(k), to ensure that you stay in the lower tax bracket. And because Roth IRAs don’t have RMDs, you can shift the amount that you withdraw from year to year, to compensate for fluctuations in your taxable income sources.
Another benefit to having a blend of sources to draw from is if you expect to live a very long life. RMDs kick in at age 70 1/2 for traditional IRAs, which could mean that you might run out of money if you live a very long time past age 70. Having a blend of Roth IRA and traditional IRA funds means you can leave your money in your Roth IRA, taking only the RMDs from your traditional IRA, and as your traditional IRA funds run low, you can then start withdrawing from your Roth. This allows your Roth funds to continue to grow tax-free while you are whittling down the assets in your traditional IRA.
In my opinion, there are a lot of reasons to choose a Roth IRA over a traditional IRA, assuming you have the choice. Some other finance writers have some reasons why a traditional IRA might be a better way to go, but on balance, I’m a big fan of the Roth. If you’re undecided, then I would split your retirement contributions between Roth and non-Roth accounts, to give yourself flexibility later on.
* Do I Make Too Much Money to Contribute to a Roth IRA? (The Backdoor Roth)
* If You Have $8,000 Left Over, Put $5,500 in A Roth IRA, Regardless of Your Tax Bracket