Traditional IRA Vs Roth IRA – Why It Matters

As financial expert, I believe it's really important to make sure I can act as a resource in my community for those with financial planning questions or concerns. This is one of the main reasons I like to teach classes (click here to view a list of our upcoming classes.)

Recently at one of these classes, one person, let's call him Robert, asked about something that many of you AdvancedFolio readers, should also understand. He asked, “What are the differences between a traditional IRA and a Roth IRA and why should it matter to me?”

I told Robert and the rest of the attendees that choosing between a traditional IRA and a Roth IRA can significantly affect long-term savings. So it is worth understanding the differences between them in order to make informed decisions. Let me explain to you what I explained to them.

You see, both traditional and Roth IRAs provide generous tax breaks, but it's a matter of timing when you get to claim them. Generally, traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with traditional IRAs, you avoid taxes when you put the money in. With Roth IRAs, you avoid taxes when you take the money out.

Therefore, it is important to consider whether your expected income, and resulting income tax, will increase or decrease in retirement.

Of course, it's hard to predict what federal and state tax rates will be 10, 20 or even 40 years from now. But you can ask yourself some basic questions to think about your personal situation: Which federal tax bracket are you in today? Do you expect your income, which will include Social Security benefits, to increase or decrease in retirement?

Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about this. Once the kids are grown and you stop saving for retirement, you lose some valuable tax deductions and tax credits, sometimes leaving you with higher taxable income in retirement.

What about tax rates generally? I asked Robert whether he expects tax rates to be higher or lower when he retires based upon current fiscal and political policies? “Higher” he responded. That logic leads to the conclusion that Roth IRAs may be the better long-term choice.

Another consideration in choosing between a traditional IRA and a Roth IRA, which I explained to the attendees, is contribution limits. Anyone with earned income, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions.

I explained to the class that another major difference between traditional IRAs and Roth IRAs is that traditional IRAs require minimum distributions (RMDs) beginning at age 73 or 75, depending on when you were born.

Roth IRAs, on the other hand, do not mandate withdrawals during the owner's lifetime. So, if you don't need the money, Roth IRAs can continue to grow tax-free throughout your lifetime, making them ideal vehicles with which to transfer wealth. Beneficiaries of Roth IRAs do not pay income tax on withdrawals and can stretch distributions over many years.

Both traditional and Roth IRAs allow owners to begin taking penalty-free, "qualified" distributions at age 59 1/2. However, Roth IRAs require that the first contribution be at least five years before qualified distributions begin. Roth contributions (but not earnings) on the other hand, can be withdrawn penalty and tax-free any time, even before age 59 1/2.

I went on further to explain a few more things to consider when choosing between traditional and Roth IRAs. As mentioned above, contributions to traditional IRAs generally can lower taxable income in the contribution year, which lowers adjusted gross income, thereby making some additional tax incentives available, such as the child tax credit and/or the student loan interest deduction.

Another consideration for him is that up to $10,000 can be withdrawn from a traditional IRA without the normal 10 percent early-withdrawal penalty, if the funds are used to pay for qualified first-time homebuyer expenses. However, income taxes must be paid on the distribution, which can drastically eat away at the benefit. Five tax years after the first contribution, up to $10,000 of Roth earnings can also be withdrawn penalty-free to pay for qualified first-time homebuyer expenses.

Roth IRAs and traditionl IRAs may seem like similar pieces to an investment plan, but making the correct decision is based on your specific strategy. Make sure you have all your questions answered before you make your move.

If you would like to learn more about how to minimize your taxes in retirement, register for our upcoming webinar here: https://register.advancedfolio.com/get-the-411-on-roth-conversions/