If you’re considering adding an Individual Retirement Arrangement (IRA) as part of your overall retirement plan, you may be wondering whether a Roth or traditional account will work better.
Depending on your circumstances, it could be either, or it can even be both.
What is a Traditional IRA? – Basics
Traditional IRAs allow you to save up to $5,000 ($5,500 for 2013) in a self-directed, tax deferred account. You can also increase the amount of that contribution by $1,000 if you are age 50 or older.
Not only will this allow you to build your own retirement portfolio, but you can also contribute to an IRA even though you’re covered by another retirement plan. However there are limits on the tax deductibility if you are covered by another plan.
For single taxpayers, the IRA deductibility begins to phase out with an income of $58,000 per year. It completely phases out at $68,000.
For married couples filing jointly, the tax deduction begins to phase out at $92,000 per year. It is completely phased out at $112,000 per year.
If you are married filing jointly and your spouse is covered by a retirement plan – but you are not – your IRA is fully deductible with an income of up to $173,000, after which it begins to phase out. At $183,000, the IRA is no longer tax-deductible.
Even if you are over these income thresholds, you can make a non-deductible contribution. Even though the contribution itself will not be deductible from your taxable income, the earnings on the contribution will be tax-deferred until time of withdrawal.
You can begin taking distributions from a traditional IRA at age 59 1/2. If you take distributions before reaching that age you can be subject to an early withdrawal penalty of 10%, in addition to the fact that the amount of the distribution will be added to your taxable income for the year taken.
You will also be required to start taking distributions from a traditional IRA no later than age 70 1/2. These are referred to as “required minimum distributions”, or RMDs. If you do not begin taking the RMDs by that age you will be subject to penalties.
What is a Roth IRA? – Basics
Just like a traditional IRA, a Roth IRA is also a self-directed, tax-deferred account. The contribution limits for a Roth are the same as they are for traditional IRA, at $5,000 ($5,500 for 2013), plus an additional $1000 if you’re age 50 or older.
The most fundamental difference between a Roth IRA and a traditional, is that while the traditional IRA contribution is tax-deductible in the year taken, the Roth IRA contribution is not.
The upside of this however is that there is no penalty or tax on the early distribution of the Roth IRA contribution portion, as long as the plan has been in existence for at least five years. This is because the Roth IRA contribution was not tax-deductible in the first place.
The next major difference is in how the distributions of the income earned on a Roth IRA are handled for tax purposes.
Once you reach the age of 59 1/2, if the plan has been in existence for at least five years, not only will your contributions be withdrawn tax-free, but so will the earnings. In other words, no tax consequences on withdrawal.
In addition, Roth IRAs are not subject to RMDs when you turn 70 1/2. That means that you can continue to allow your earnings to grow quite literally for the rest of your life if that’s you choose to do.
Roth IRAs, like traditional IRAs, are also subject to phase out based on your income.
However unlike traditional IRAs, once you reach the Roth IRA maximum income limit, you cannot make a contribution at all.
A single taxpayer can make a full Roth IRA contribution on an income of up to $110,000 per year, after which it begins to phase out. At an income of $125,000, a contribution will no longer be permitted.
For married filing jointly, the Roth IRA contribution begins to phase out with an income of $173,000, and disappears completely at $183,000. If you are married filing separately, the phase out begins with an income of zero, and disappears with an income of $10,000.
You can actually have both – but there‘s a catch
As long as you qualify based on income limits you can actually have both a traditional and the Roth IRA. The catch however is that your combined contribution to both cannot exceed the limit for one.
That means you can contribute no more than $5,000 ($6,000 if you’re 50 or older) between both plans. You will for example, be able to contribute $2,500 to a traditional IRA and $2,500 to a Roth IRA, because you have not exceeded the $5,000 contribution limit for a single plan.
With this rule you don’t have to choose either/or and worry if one plan will always be better for you.
The Roth vs. Traditional IRA debate
Which account type is best for you will depend on your own personal circumstances.
What is the biggest concern perhaps is what you expect your tax situation to be by the time you’re retired.
If you expect that you’ll be an a lower income tax bracket at retirement, you can do well with a traditional IRA. The distributions will be taxable, however they will be taxed at a lower rate than you’re currently paying.
If you anticipate that you’ll be in a higher tax bracket, or at least a high one, you’ll do better with a Roth IRA. Since the distributions will not be subject to tax, you can take them without increasing your taxable income.
Still another factor is expected longevity.
If you are in excellent health, and the members of your family have a history of living well into their 90s, the Roth IRA will be the better choice. This is because, unlike a traditional IRA, you will not be required to take RMDs. The money in your Roth account can continue to build – tax-free – to be withdrawn when you’re well past 70 1/2. With the Roth account, you’ll probably never run out of money (assuming you’ve been funding it all those years and it’s grown in significant value).
As you can see there are some factors you need to look at when deciding whether a Roth or Traditional IRA are best for you. As important a decision which type to pick is, don’t get stuck in analysis paralysis and not invest at all.
The sooner you start your retirement saving and investing the better you will be later on.
Although I expect to earn less in retirement, I still have both an IRA and Roth IRA. I am ineligible because I have a pension, but I contribute to my wife’s IRA. I contribute to a Roth IRA as a hedge because I don’t know if I will be in a hi gher tax bracket. Better safe than sorry.
Glen Craig says
You have the option to invest in both so long as you stay within the contribution limits so it makes sense to have both in my opinion because as you say you can’t tell for sure what your income will be.
My rule of contributing is. 1. Max out your employer plan first. Then a Roth IRA. On the other hand if you are a small business owner, you may want to look at SEP and Simple IRA’s instead of a traditional IRA since they have potentially higher contribution limits
Glen Craig says
Totally agree with you on an employer plan, assuming they have a company match. Also on your small business advice (though I hear a solo 401k is a good option too).
Is there a particular reason you use a Roth rather than a Traditional?
Well, I was assuming an employer plan option was available. So in most cases if you are already contributing to your employer plan, your ability to contribute to a traditional IRA is greatly diminished. Also, I personally think that taxes are going up, not down in the longer term, so having my retirement funds (and capital growth) tax free is a nice thing!
Glen Craig says
Thanks for the follow-up Andy!