Image of Roth IRA vs Traditional IRA written in the notepad with a line between the two columnsDo you own an IRA? Are you considering it? If so, which should you hold – 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 many of these questions.

NOTE: This information is provided for general information only, and is not intended as personalized investment advice. This presentation is not intended to be any form of financial planning, investment, tax or legal advice. There is no substitute for individualized investment advice, and no conclusions should be drawn from this information. All readers should contact their professional investment, legal and tax advisors before entering into any investment or investment agreement. 

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 2018 limit was $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. For 2019, the limit increased to $6,000 for those under age 50 plus the $1,000 catch up for those age 50 and over.
  • 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. Instead, 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 ($6,000 under age 50, $7,000 for age 50 and up in 2019) subject to income contribution limits.

How a traditional IRA works

Some of the basics:

  • Contributions to traditional IRAs may be tax-deductible. If participating in 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.

Image of chart showing 2018 & 2019 income and deduction limits for traditional iras

Source: Nerd Wallet

Traditional IRA withdrawal rules – general

If you took a tax deduction for your traditional IRA contribution, any withdrawals from that account are taxed. If you withdraw money before reaching age 59 1/2, you will pay an additional 10% penalty on top of the regular 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). Don't let this keep you from 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 distributions

[socialpug_tweet tweet=”Once you reach age 70 1/2, the IRS requires you to begin making withdrawals over the rest of your life.” display_tweet=””]

Called required minimum distributions (RMDs), three factors determine how much you must withdraw.

  1. Age
  2. Life expectancy (from the uniform IRS lifetime table.
  3. 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.

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. Careful analysis and ongoing monitoring are critical to getting it right.

Related:
Naming IRA Beneficiaries – 7 Things You Need to Know
When Transferring Retirement Accounts Which is Best – Direct, or Indirect Rollover?

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

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.

Image of chart showing 2018-2019 Roth IRA income and contribution limits

Source: Nerd Wallet

Roth IRA withdrawal rules

One of the most significant 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 five 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. You can take out contributions without the 10% penalty. That's a huge advantage over traditional IRAs?

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:

  1. Who in their right mind can predict future tax rates? The answer, of course, is no one. The chances of success are about as good as meteorologists predicting long-term weather. Or what about the stock market prognosticators? Would you want to rely on their success rates? I wouldn't. Predicting future tax rates is a losers' game.
  2. 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.

You might also like:
16 Ways to Avoid the 10% Early Withdrawal Penalty
Retirement Planning is About More Than Just Money

Managing taxes before and during retirement

Don't get me wrong. Managing taxes before and during retirement is essential. 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 $6,000 for those under age 50) for 20 years at 6% annual return; you would accumulate $220,714 At a 22% tax rate, the cumulative value of your tax deduction is $26,400 That's the good news.

You will owe taxes on $220,714, the full amount of your IRA, over your lifetime. The cumulative tax bill on the money, assuming the same 22% tax bracket is $48,557 That's slightly over $22,000 more than the amount you deducted for the contributions. Even assuming a 15% tax, you would still owe $33,107 in taxes.

The money is taken out over life expectancy. Assuming you still have the money invested, the money in the IRA will continue to grow, which will increase the money subject to tax.

Keep in mind this is a very simplified example. It also assumes tax brackets stay the same. That's something no one can predict. Having a mix of Roth and traditional IRAs offers options when withdrawing money for retirement income. It's always good to have options for tax-free income. A Roth IRA is one of the best ways to get that.

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 22% tax bracket, you would owe $22,000 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. 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 22%, 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 many years reduces the amount in traditional IRAs. That, in turn, reduces the amount of RMDs at age 70 1/2, giving you more control of your retirement income.

Can I undo the conversion if things change?

Before 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. You could undo the conversions as if they never happened. There are a variety of reasons to undo a conversion. The new tax law took away the Roth recharacterization option.

This is another reason why you need to analyze whether a Roth IRA conversion makes sense carefully. Because now, once you do it, there is no reversing it.

Final thoughts

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. 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 vital 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!

Additional resources

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. Charles 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 – The site offers numerous resources and other calculators.

Charles Schwab

Fidelity Investments