Saving for Retirement: Roth vs. Traditional IRAs

Bird balancing on a rope between the pier an a boat. We can have the same difficulty choosing between a Roth and a traditional IRA.
A question I get asked frequently is whether a client should invest in a Traditional IRA or Roth IRA. Unfortunately, this isn’t always an easy choice.

Anyone who has spoken to me (at least about retirement accounts) knows that I am a big fan of Roth IRAs. But as much as I think Roth IRAs are a great resource to use to fund your retirement, they aren’t always the best option for every person.

Why not?

To understand, we need to look at the differences between these two types of accounts. The main difference is the timing of taxation. Roth IRAs are taxed at the time of contribution, while traditional IRAs are taxed at the time of distribution. You either pay a tax now or pay it later. So, to figure out what is the best option just ask yourself “Will I be in a higher tax rate now or in retirement?” Unless you have a crystal ball, this may not be a question you can easily answer. Regardless of your personal situation, we don’t know what tax rates will even look like in the future.

Since we don’t know what tax rates will look like in the future, let’s look at characteristics that differentiate the two account types.

Required Minimum Distributions (RMD)

With Traditional IRAs you must take mandatory distributions starting at age 70 ½. It starts out as a small percentage (3.6%), but increases over time (5.3% at age 80 and 8.8% at age 90).

Most people have started to spend down their retirement funds at this age, so the mandatory distributions of traditional IRAs aren’t an issue. But, the “required” part doesn’t sit well with others. For them, Roth IRAs may be a better choice since Roth IRAs have no required distributions and the money can continue to grow tax-free indefinitely.

Age and Income Limitations

Anyone under age 70½ with earned income can contribute to a traditional IRA. Whether the contribution to a traditional IRA is tax deductible depends on your annual income, tax-filing status and if you and your spouse are covered by an employer retirement plan. Alternatively, Roth IRA contributions do not have an age limit, but do have an income limit depending on your tax filing status. In 2014 the limit for Roth IRAs was up to $129,000 for single filers or $191,000 for married couples filing jointly.

Penalty on Early Distributions (availability of your contributions)

Most distributions from a traditional IRA before age 59 ½ are subject to a 10% penalty, even if they represent your own contribution dollars. Some exceptions do apply.  In contrast, distributions from a Roth IRA that represent your contributions (the principal of the account) are not subject to any penalty. The growth of the account could be subject to a similar penalty if it is not a qualified distribution.

Keep in mind that you aren’t locked into this decision for life. Each year you can look at your personal situation and the needs you have to help you make the best decision. Your income level, available deductions, tax rate, and retirement expectations will all play a role in your choice. Everyone has a different situation and different goals for their future, so each of these pieces factor into this decision.

At the end of the day, it is best to start retirement with a variety of account types based on their taxation (tax diversification). In a perfect world, you would have a healthy balance in a Traditional IRA, a Roth IRA, and a taxable account. This will give you the flexibility to manage your tax rate during retirement.

Do you have more questions about the right vehicles for retirement savings? We help residents of McKinney, Frisco, Allen and the surrounding areas in North Texas develop financial plans that answer just those types of questions. Please get in touch for more information about how we can help you gain peace about your financial future.

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