There are two types of tax advantaged individual retirement accounts (IRAs): the Roth IRA and Traditional IRA. Taxed advantaged IRAs allow you to put a certain amount of money away for retirement with a tax advantage. These plans exist to incentivize Americans to save for retirement. There are various types of retirement plans allowed under the tax code, most of which contain a Roth IRA and a Traditional IRA option. The amount of money that can be put into an IRA (whether Roth IRA or Traditional) is limited by the type of plan.
For individuals, up to $5,500 can be contributed per year to an IRA. If your employer has a Simple IRA plan, you can contribute up to $12,500, and there will generally be an employer contribution as well (see this article for more detail.) Larger employers often provide a 401k plan, which allows up to $18,500 to be contributed each year. The employer sponsored plans will generally have a few low cost EFTs or Mutual Funds to invest in. W
Whether you have a plan as an individual or under your employer’s Simple or 401k plan, you need to decide whether to contribute the money to a Traditional, or Roth IRA. So what’s the difference?
Roth IRA
The first, and often less appealing option is the Roth IRA. The reason the Roth can be less appealing is that you generally pay more tax now and less later. When you contribute to a Roth IRA, you do not deduct the amount contributed from your taxable income. That means that the money put into a Roth is “after-tax” money. You would need to earn $6,250 if you are in the 22% tax bracket (using the new tax rates) in order to put $5,500 into a Roth IRA.
What’s the advantage?
The advantage of a Roth IRA is two-fold… first, when you take the money out in retirenment (after 59 and 1/2 currently) you pay NO TAX. You have already paid tax on the principal you paid in, but any earnings are tax free as well. If your Roth IRA contribution of $5,500 is $11,000 by the time you retire, your tax bill upon pulling out the money is $0. The second benefit is that you can pull out the principal that you put into the Roth IRA without paying any penalty, even before retirement age. This is because you have already paid tax on the income. You cannot, however, pull out the earnings without potentially paying tax and penalties. Depending on the age of the account and the use of the withdraw, you may be able to avoid some penalties and taxes on these withdraws.
When is it best to use a Roth IRA?
The conventional wisdom is that a Roth IRA performs best for those early in their careers. This is because the advantage of the account grows as the earnings grow. The longer you have the account, the more time there is for the balance to earn something. Since those early in their careers have a long way until retirement, this benefit is particularly pronounced. Your account balance probably won’t double or triple in 5 years, but over 30 or 40 years of investment it just might. The Roth is also at its best when you are in lower tax brackets (usually early in your career.) This is because the tax break that you are foregoing is lower than it will be when you are at your highest earning potential.
Roth IRAs can also be used as a safety net due to the lack of penalty for withdrawing what you contributed. Your Roth could potentially be a rainy day fund as well as a retirement asset without handing a chunk of it over to the IRS if you ever need to dip into it.
Traditional IRA
The Traditional IRA is more appealing on the surface because you save tax dollars today. Any contribution offsets your taxable income dollar for dollar. If your gross income is $100,000 and you contribute $5,500 to a Traditional IRA, your taxable income would be $94,500 (before all other tax deductions.) That would be a tax savings of $1,210 if you were in the 22% tax bracket. The retirement age for pulling money out of a Traditional IRA is the same as a Roth (59 and 1/2). However, when you pull the money out of a Traditional IRA, all of the money you withdraw is taxed as ordinary income. There is no capital gains treatment for the earnings on a Traditional IRA.
What’s the advantage?
The advantage of a Traditional IRA is that you essentially get to earn money on what you would have paid in taxes. If you planned on using $5,500 of income to fund retirement, it would only be $4,290 after taxes in a Roth or ordinary investment account (at the 22% rate in this illustration). So the additional $1,210 will grow until you pull it out in retirement. One disadvantage of an IRA is that there is a penalty for pulling the money out before 59 and 1/2. Whatever you pull out is taxed at your marginal rate, and you get hit with a 10% penalty. There are some exceptions where the penalty is waved, but you will always pay tax on what you withdraw as ordinary income.
When is it best to use a Traditional IRA?
A traditional IRA is best when you are at the height of your earning potential. The higher your tax rate, the larger the amount that is tax deferred. Traditional IRAs can also be used to lower your AGI in order to qualify for some credits or deductions that were phased out. In this way Traditional IRAs can be used as effective tax planning tools.
The other tax planning theory behind the Traditional IRA is that your tax rate will be lower once you start taking out the money in retirement. You will most likely have stopped working, and be drawing on other retirement assets such as Social Security. In most cases this means your tax rate is lower, so you effectively traded paying a high tax rate on the income earlier for paying a lower rate later.
Overall both the Roth and the Traditional IRA provide excellent opportunities to save for retirement. Your investment strategy will also play a role in how the two types of accounts work for you. To learn more about this, contact a trusted financial advisor. We would be happy to answer any tax planning questions regarding retirement investment.
