Do you own an IRA? Are you thinking about it? If so, which should you own – a Roth IRA or Traditional IRA? The answer for you may be both. There are benefits to each that we will explore in this post. This post will not include a discussion about investments in your IRA. I'll save that for another day.,
We will discuss in some detail how each IRA works. What are the advantages of each? Are there disadvantages? Does age make a difference in which IRA you choose? What about income?
I'll attempt to answer all of these questions and many more. So, let's jump right in.
What the Roth IRA and traditional IRA have in common
- There is a limit to how much you can contribute each year. Those limits are the same for both. The limit is $5,500 per year. If you are age 50 or older, the IRS allows a catch-up contribution of an additional $1,000. So, if you're age 50 and up, you can contribute $6,500.
- If you own both a traditional and Roth IRA, you cannot contribute maximum contributions to both.
- The limits apply to total contributions across both IRAs.
- You must have earned income to contribute to either a Roth or traditional IRA. Contributions cannot exceed your earned income for either. There are, however, maximum limits to income that may inhibit or restrict your ability to contribute (more on that later).
- The deadline for contributing to either IRA is (typically) April 15 of the following year.
- Neither the Roth IRA or traditional IRA is an investment. Rather, they are accounts that receive contributions. You can open an IRA at a bank, credit union, brokerage firm, insurance company, and other financial institutions. There is a long list of allowable investments for both Roth and traditional IRAs. There is also a list of prohibited investments, which we will discuss shortly.
- A working spouse can open a traditional or Roth IRA for a non-working spouse. Contribution limits for spousal IRAs are the same as for those with earned income ($5,500 under age 50, $6,500 for age 50 and up) subject to income contribution limits.
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How a traditional IRA works
Some of the basics:
- Contributions to traditional IRAs may be tax-deductible. If you're covered under a retirement plan at your workplace, your contribution may be fully or partially deductible. It may also be non-deductible. The IRS determines this based on your modified adjusted gross income (MAGI). (see table below) This is your adjusted gross income calculated without certain deductions and exclusions. To learn the difference between MAGI and adjusted gross income (AGI) read, What's the Difference between AGI and MAGI on Your Taxes? TurboTax published this article about the 2017 tax year.
- Earnings on contributions grow tax-deferred while in the account. If you made tax-deductible contributions, withdrawals of those contributions and earnings get taxed. If you make withdrawals before reaching age 59 1/2, you owe an additional 10% penalty on top of the tax.
- You can make contributions as long as you have earned income up to age 70 1/2. Once you reach age 70 1/2, you can no longer contribute.
Traditional IRA withdrawal rules – general
If you took a tax deduction for your traditional IRA contribution, any withdrawals from that account will be taxed. If you withdraw money before reaching age 59 1/2, you will pay an additional 10% penalty on top of the normal tax. Tax rates on IRA withdrawals are at ordinary income tax rates. If you own stocks, mutual funds, or ETFs, you lose the advantage of long-term capital gains tax rates (15% or 20% depending on income). This shouldn't be a deterrent to owning a traditional IRA. However, it should be considered when looking at your overall tax and retirement planning picture.
Withdrawals made between age 59 1/2 and 70 1/2 are not subject to the 10% penalty.
Required minimum distributionsOnce you reach age 70 1/2, the IRS requires you to begin making withdrawals over the rest of your life.
Called required minimum distributions (RMDs), there are three factors that determine how much you must withdraw.
- Life expectancy (from the uniform IRS lifetime table.
- Your account balance on 12/31 of the year before you turn age 70 1/2
To calculate your RMD, find the age you are in the year the distribution is due. Look at the factor (number of years) that corresponds to your age. Divide that into your prior year account balance to determine that year's RMD.
Your first withdrawal must be taken by April 1 of the year following the year you turn age 70 1/2. Keep in mind, if you delay your first RMD, the IRS requires that you take the previous year's RMD and the current year's RMD in the same year. That may cause you to pay a higher tax bill than if you spread the withdrawals over two years. Read my recent blog post, Rules and Deadlines for Required Minimum Distributions (RMDs) to learn more.
A big part of retirement income planning is determining the most tax efficient ways to get cash out of your various investment accounts. There are many schools of thought on this. In my experience, the financial advice industry often gets this wrong. Careful analysis and ongoing monitoring are critical to getting it right.
Traditional IRA advantages
- Potential tax deduction for contributions
- Earnings grow tax-deferred as long as they stay in the account
- Numerous investment options available
- Ability to make non-deductible contributions regardless of income for tax-deferred growth
Traditional IRAs disadvantages
- In most cases, withdrawals get taxed at ordinary income rates
- An additional 10% penalty paid for pre-59 1/2 withdrawals
- Required minimum distributions at age 70 /1/2 for life
- May increase the amount of Social Security that's taxable
- May increase exposure to the 3.8% Medicare tax
- Loss of control over withdrawals and taxes after age 70 1/2
How a Roth IRA works
Some of the basics:
- Contributions are not tax deductible
- There is no age limit for contributions
- Earnings grow tax-deferred while in the account
- Contributions can be withdrawn tax-free
- There is no pre-59 1/2 penalty on withdrawals of contributions
- Withdrawal of earnings, if from qualified distributions, are tax-free
Roth IRA income limits
Unlike traditional IRAs, you can open and contribute to a Roth IRAs even if you participate in an employer-sponsored retirement plan. However, the income limits may restrict you from doing so. With traditional IRAs, the income limits reduce the tax deductibility of your contributions. With a Roth, the income limits reduce the amount you can contribute.
Below are the IRS MAGI table and calculation instructions.
Roth IRA withdrawal rules
One of the greatest advantages of Roth IRAs is that there are no RMD requirements. Though you lose the upfront tax deduction, you gain the flexibility of choosing how and when you take withdrawals. There are no taxes due on Roth IRA withdrawals if you are over 59 1/2 and the account is at least 5 years old. These are called qualified withdrawals. If you are under age 59 1/2 when making withdrawals, you would owe a 10% penalty on the earnings. Contributions can be withdrawn without the 10% penalty. That's a huge advantage over traditional IRAs?
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Taxes and the Roth IRA
One of the arguments made for or against using Roth IRAs involves tax rates. The theory goes that if you presume you will be in a higher tax bracket in retirement than you are now, you should be in a Roth IRA. Conversely, if you expect lower tax rates in retirement, put your money in a traditional IRA and get the upfront tax deduction. Here are two problems I have with this argument:
- Who in their right mind can predict future tax rates? The answer, of course, is no one. Those that do have the same chance of success as meteorologists predicting long-term weather. Or what about the stock market prognosticators? Would you want to rely on their success rates? I don't think so. Predicting future tax rates is a losers' game.
- Regardless of tax rates, the RMD requirement of traditional IRAs forces you to take withdrawals whether it makes sense for you or not. Proper planning can reduce the amount of those RMDs. Still, you have no choice in the matter once you reach age 70 1/2.
Managing taxes before and during retirement
Don't get me wrong. Managing taxes before and during retirement is important. However, focusing on a current tax deduction can increase your tax bill in retirement. How? Let's say you're contributing the maximum amount to your IRA every year (let's say $5,500 for those under age 50) for 20 years at 6% annual return, you would accumulate $214,460. At a 25% tax rate, the cumulative value of your tax deduction is $27,500 That's the good news.
The bad news is you will owe taxes on $214,460, the full amount of your IRA. Granted, that will be paid over your lifetime. But still, the cumulative tax bill on that money, assuming the same 25% tax bracket is $53,615. That's almost twice the amount you deducted for the contributions. Even assuming a 15% tax, you would still owe $32,169 in taxes. Either way, you will pay more.
And remember, the money is taken out over life expectancy. Assuming you're still invested, the money in the IRA will continue to grow, which will increase your taxes even more!
What if I make too much to contribute to a Roth IRA?
That's a legitimate question and a concern for many investors. If you make too much money to make partial or full contributions to a Roth IRA, there is still a way to participate. How? Through a Roth conversion. A Roth conversion allows you to move money from traditional IRAs to Roth IRAs. Conversions can be done in whole or in part. If you have multiple IRAs, you can convert some or all of them.
When you move money from a traditional IRA to a Roth IRA, you pay taxes on the transferred money for the year you converted. Let's say you convert $100,000 to a Roth this year. Assuming a 25% tax bracket, you would owe $25,000 in taxes on the converted money. (Of course, this isn't a complete picture. It doesn't account for deductions, etc.) That's a big bill, right? That's why you work with your financial and tax advisors to figure out if a conversion makes sense from a tax standpoint (both now and in the future).
A strategy I've used with clients who want to move into Roth IRAs is to use the fill up the bracket formula. In this strategy, we would convert enough money to fill up the income to the highest tax bracket the client currently pays. If it's 25%, we convert just enough money so we don't push the client into the next higher tax bracket. That's why it's important to pay attention to tax brackets when converting.
Spreading conversions out over a number of years reduces the amount in traditional IRAs. That, in turn, reduces the amount of RMDs at age 70 1/2. This gives you more control of your retirement income.
Can I undo the conversion if things change?
Prior to the Tax Cuts and Jobs Act, the answer was yes. If you did Roth conversions, you had until October 15 of the following year to “recharacterize” the conversion. Basically, you could undo the conversions as if it never happened. There are a variety of reasons to undo a conversion. To read more about that, go to my blog post, A Major Change is Coming to Roth IRAs. The new tax law took away the Roth recharacterization option.
This is another reason why you need to carefully analyze whether a Roth IRA conversion makes sense. Because now, once you do it, there is no reversing it.
There is a lot to think about when considering which IRA is best for you. Personally, as you might have guessed, I am a raving fan of the Roth IRA. I love them because of the control they give you. For decades, advisors focused solely on the tax deduction provided by the traditional IRA. As I've shown you, when you calculate it carefully, you often end up paying more taxes in total in a traditional IRA scheme.
Most people own both traditional and Roth IRAs. In fact, it's a good planning strategy. Many people also have 401(k) or other company retirement plans when they retire. There are lots of options to consider when deciding what to do with all of these things. Careful analysis is important in making the decision. Talk to your advisor and y our CPA about it. If you don't have an advisor, take a look at the resources I've listed below.
If you have additional questions, you can get in touch with me here. Good luck!
Most mutual fund companies offer tools to help you determine which IRA makes sense for you. Be careful, though. Look for independent resources. Unfortunately, many of the mutual fund and brokerage sites will try to push you to their products or open an account with them. The first two on the list appear to be the most independent. Schwab, TD Ameritrade (my firm's custodian) and Fidelity have great resources but they, of course, want you to do business with them. At least you can search without the pressure of a broker.
Anyway, here is a list:
CalcXML – This website offers a variety of calculators on a variety of topics. This can provide a good baseline starting point for many financial decisions. This page, Should I Convert to a Roth IRA, takes you to a calculator that will run the numbers on whether a Roth conversion makes sense.
BankRate.com – Another Roth conversion calculator. The site offers numerous resources and other calculators.
For further reading: