If you are trying to decide between putting your retirement savings in a Roth IRA vs. a traditional IRA, you could pretty much spend the rest of your life reading all of the articles that have been published on the topic. My goal here is to give a real-life nuts and bolts summary of important information that will help you make the best financial decision for your situation. First, lets cover the basic similarities and differences:
In 2018 you can contribute up to $5,500 for both Roth and traditional IRAs. If you are older than 50, you can contribute up to $6,500. For 2019, the contribution limits will increase to $6,000, and $7,000 if you are older than 50.
- Traditional IRA – Anyone can contribute to a traditional IRA regardless of income level. However, whether or not your contribution is tax deductible does depend on your income and whether or not you or your spouse have an employer sponsored retirement plan. You can find the specifics at irs.gov.
- Roth IRA – You can only make direct contributions to a Roth IRA if your income is below a certain level, which can change each year. For 2019, you can contribute to a Roth IRA if your income is less than $137,000 for single filers and $203,000 for married couples filing jointly. Don’t get too hung up on the income limit for Roth, because there is a way to get money into a Roth IRA account regardless of your income; it’s called a Roth conversion and is also known as a “backdoor Roth”. We’ll cover that in an upcoming article.
The timing of taxation is the most important difference between a Roth IRA and a traditional IRA. Both types of accounts give you important tax breaks, but at different times.
- Roth IRA – your contributions are made out of your taxable income. You can not deduct your contributions from your income to reduce your taxable income in the year you make the contribution. YOU ARE TAXED ON THE CONTRIBUTION BEFORE IT GOES INTO YOUR ROTH IRA. But when it is time to take money out of the Roth IRA, YOU PAY NO TAXES ON YOUR DISTRIBUTIONS.
- Traditional IRA – YOUR CONTRIBUTIONS ARE TAX DEDUCTIBLE (provided that you meet the IRS guidelines for qualifying for the deduction). This means that you will be able to reduce your taxable income, and therefore, the amount of income tax you pay in the year of your contribution. When it is finally time to take money out of your traditional IRA, YOU ARE TAXED ON YOUR DISTRIBUTIONS as ordinary income.
TAKE-HOME MESSAGE: with a Roth IRA you are taxed now and with a traditional IRA you are taxed later.
A Roth IRA gives you more flexibility with withdrawing your money. Here are the most important differences when it comes to taking your money out of your Roth vs. traditional IRA:
- Required minimum distributions (RMD) – With a traditional IRA, the IRS says that you must start taking distributions when you reach the age of 70 ½. These distributions are not required with a Roth IRA and you actually never have to take distributions from a Roth IRA in your lifetime if you don’t want to.
- Qualified distributions – You can think of qualified distributions as normal, penalty-free distributions. Both Traditional and Roth IRAs allow you to begin taking penalty-free, “qualified” distributions at age 59½.
- First time home buyer withdrawal – Both the Roth and the traditional IRA will allow you to withdraw up to $10,000 for qualified first time home-buyer expenses if you are under age 59 ½.
- Roth IRA withdrawal flexibility – you are free to withdraw your Roth IRA contributions (but not earnings) at any time without a penalty, even if you have not yet reached the age of 59 ½. This benefit adds versatility to how you can use your Roth IRA funds.
Okay, now we have the basics of Roth IRA vs. traditional IRA, but you are probably still thinking: “Alright, so what? Which one should I pick?” It essentially depends on your tax rate now vs. your tax rate when you are taking distributions.
- Favor a Roth IRA if: you expect that in retirement you will be in a higher tax bracket than you are now.
- Favor a traditional IRA if: you expect that in retirement you will be in a lower tax bracket than you are now.
Of course, it is impossible to know exactly what your tax rate is going to be decades from now, but…In general, if you are in the lower tax brackets, now, consider a Roth IRA. If you are in the higher tax brackets now, consider a traditional IRA.
I can’t resist plugging Roth IRAs here: If you are young and at the beginning of your working life, OPEN A ROTH IRA TODAY. It could be one of the best financial decisions you every make. Since you are not making much income now and are paying little or no income tax, your contributions will be taxed at a very low rate. Those contributions will grow into a big pile of money over your working life, and when you withdraw the money in retirement, you won’t pay any taxes on it. This is one of the few times that the IRS allows a “free lunch” on taxes like this. Take advantage of it while you are young and poor!
We will go into more details and specific situations in future articles, but this information should give you a good foundation for understanding the basics of Roth IRAs and traditional IRAs.