“Whether ’tis Nobler in the mind to suffer the slings and arrows of deferred taxation or to take arms against a tax bomb and, by paying up front, diffuse it…”
Gimmicky, I admit, but it addresses a question that we hear nearly every day from people concerned about building an optimal retirement strategy, “is it better to utilize a Roth or Traditional IRA?” We always answer swiftly and without equivocation, “it depends”. Just like all financial instruments, there are a lot of complexities, and the cost versus the benefits of the two are different for every individual. But, knowing some of the major distinctions between the two is helpful as you decide which one is best for you.
The first rule of any type of IRA is contribute, contribute, contribute. But there are some rules you have to abide by. There are no age limits for contributing to a Roth IRA, but you must be younger than 70 ½ to make contributions to a traditional IRA. So, if you plan to use it solely for retirement income, a traditional IRA may be fine. But, if you want to build a legacy for your beneficiaries after you “shuffle off this mortal coil”, the Roth might make more sense because you can continue to grow your savings, and your beneficiaries also won’t be left with the tax burden. The amount you can contribute to either type of IRA in any given year can’t exceed $5,500 if you’re younger than 50 or $6,500 if you’re older than 50. And if you earned less than those amounts in any given year, your contribution can’t exceed your total earned income for that year. On the high end of this equation, you can only contribute to a Roth IRA provided your yearly income is below $196,000 if you’re married and filing jointly, and $133,000 if you’re single. But you should note that these limits are subject to adjustments every year, so it’s smart to work with a financial advisor to stay on top of any changes.
Similar to the age limit for contributions to traditional IRA accounts, there is an age requirement for when you must begin taking Required Minimum Distributions (RMDs) from traditional IRAs. Eventually, Uncle Sam makes you give up that tax revenue, and he makes you begin taking those RMDs the year you turn 70 ½. You do have some flexibility in how and when you take them. For example, you can elect to take them all at once (at the end of the year, if you choose), or you can receive them throughout the year as long as you meet the amount required. There is no such requirement with Roth IRAs because you’ve already paid taxes on that income. On the other side of that coin, if you make a withdrawal before age 59 ½, there is a 10 percent penalty on both Roth and Traditional IRAs, but you will also be required to pay income tax on the amount withdrawn from the Traditional IRA in addition to the penalty.
You probably already understand that a traditional IRA is tax-deferred while your contributions to a Roth are taxed as income for the year in which you make the contribution. But that’s not the only difference between Roth and traditional IRAs when it comes to tax requirements. Now assuming you’ve met the stated requirements for your age and the holding period, there are no tax obligations when you withdraw from a Roth IRA as you already paid taxes when you made the contribution. But, withdrawals from the traditional IRA are taxed the same as your regular income for the year. However, you are allowed to make deductions on your tax return for a portion of your traditional IRA contributions. With the Roth, you don’t have that luxury. The main thing you need to ask yourself is do you expect to be in a higher or lower tax bracket once you retire? That will determine if it’s best to pay the tax on your contributions now or in the future.
This is by no means an exhaustive comparison of the two types of IRA accounts. Digging in to every detail of these types of retirement accounts would be more complex than deciphering the most esoteric Shakespearean dialogue. You’d be wise to consult a financial advisor to determine which option is the best for you to fulfill “what dreams may come”.