Traditional IRA vs. Roth
This time of year, you may be thinking about socking some money in an IRA. But which one should you use—a Traditional, or a Roth? You get more tax savings now with the Traditional, but could the Roth be the better deal in the long term? We are going to look at this issue today and in my next post as well. Something worth noting is that even though I am covering IRAs today, most of this also applies to Traditional 401k’s compared to Roth 401k’s.
If you hear about a Roth IRA on the news or read about it on the internet, you will probably get the impression it’s the greatest thing since sliced bread. You get the feeling you are in idiot to choose a Traditional IRA over a Roth. When I hear this, it causes me to roll my eyes and shake my head.
It’s not that a Traditional IRA is bad, and a Roth is good. It’s just that they are different. Both of them have their place, and both of them are excellent vehicles to grow your wealth for retirement.
Just as a refresher, a Traditional IRA is a tax-deferred vehicle. If you meet the income requirements, you receive a tax deduction for your contributions. This deduction, as we discussed in the last issue, can be significant. A $3,000 contribution can amount to $450 in tax savings if you’re in the 15 percent tax bracket. The savings would be $750 in the 25 percent bracket.
As long as you keep the money in the account, you will not have to pay taxes on any of the earnings. But beware, the taxman cometh! Beginning the year after you reach age 70 ½ (don’t ask me why the IRS doesn’t round off), you must begin taking a minimum amount out of your IRA each year, called a required minimum distribution. I won’t bore you with the math, but it works out to about 4 percent of the account value the first year. These distributions are taxable at the federal level, but not at the state level here in Pennsylvania.
A Roth IRA, on the other hand, works practically the opposite. You do not receive a tax deduction for your contributions, but the earnings grow tax free for retirement. Also, you do not have to take required minimum distributions. Uncle Sam couldn’t care less since he already collected his “share”. Once you pass away, your beneficiaries, other than your spouse, will have to take minimum distributions, but they are tax free.
The wonderful thing about a Roth IRA is the ability to get your hands on your money prior to retirement tax free for certain special situations. First, you can take out your contributions at any time without paying a dime of tax. Second, if you’ve had the Roth for five tax years, you can withdraw the earnings tax free under the following circumstances:
- You’ve reached age 59 ½
- You die. (I’m sure this will comfort all of us in the casket.)
- You are disabled.
- You, your spouse, child, or grandchild is buying a first home. There is a lifetime cap of $10,000.
- You withdraw money for educational expenses. The earnings in this case are taxable, but are not subject to a 10 percent penalty tax.
A Traditional IRA conversely, is like a marriage. Once you get in, it’s pretty expensive getting out. For most withdrawals prior to age 59 ½, the distribution will be tacked on to your income and you’ll also get hit with a 10 percent penalty tax. In other words, Uncle Sam will generally take a 25 to 40 percent cut of the proceeds. The best you can hope for is to avoid the penalty tax (while still paying regular income taxes). You can avoid the penalty if you:
- Reach age 59 ½
- Become disabled
- Initiate a Substantially Equal Periodic Payment. (I’m not going to cover this here.)
- Have medical expenses exceeding 7.5% of your adjusted gross income.
The point I’m trying to make today is that both IRAs are good tools. The one you choose depends on the job you want it to do.
Consider the Traditional IRA if:
- You need the tax deduction.
- You cannot afford to save a lot of money, and by reducing your taxes, you’ll be able to save more.
- The tax penalty for withdrawals will stop you from taking money out of your IRA unnecessarily.
- You think your tax bill will be low or nonexistent during retirement.
Consider a Roth IRA if:
- You may need to tap the account prior to retirement for a home, educational expense, etc.
- You pay low or no taxes currently.
- You can’t get the full deduction on a Traditional IRA contribution due to your high income.
- You think tax rates will rise in the future.
- You don’t anticipate needing the money during retirement, and want it designated as an inheritance.
Notice I failed to list tax free earnings as one of the benefits of the Roth. This is the main attraction for most advisors and journalists who tout the Roth. It’s also the most overrated.
What do you think benefits you more from a tax standpoint: A tax deduction now in a Traditional IRA, or tax free growth in a Roth? The answer may surprise you. This aspect will be the topic for the next newsletter.