How to Choose Traditional vs. Roth
You have probably heard the term Roth and wondered what the heck does that even mean? And no, I’m not talking about the one hit wonder, white rapper Asher Roth, who’s only major hit was about partying in college. And no I’m not talking about the actor Tim Roth, you know that guy from all those Quentin Tarantino movies like Reservoir Dogs and Pulp Fiction. I’m talking about a topic you have likely heard of but may not really know what it is or what it means – traditional and Roth IRA’s. I hope by reviewing the differences and similarities between traditional and Roth IRA’s, you make an informed decision to figure out which one is best for you.
Individual Retirement Accounts (IRA’s)
An IRA is an Individual Retirement Account. Think of an IRA as a special savings account. Just like a savings account, you can open an IRA at just about any financial institution – banks, mutual fund companies, and brokerage firms. Just like a savings account, you add money to it, and ideally on a regular basis. And just like a savings account, it builds up money over time.
An IRA is a retirement savings plan for people to save on their own outside of any employer sponsored plans like a 401(k) or a 403(b). You can have an IRA even if you already have a 401(k) at work. That means someone working at Lowe’s could open and invest in an IRA, as could a janitor at a school or someone in the military. Pretty much everyone in the US can open some type of IRA.
IRAs have several benefits compared to a typical savings or checking account and are actually pretty simple to set up. There are limits on how much money you can save in an IRA each year. The maximum annual contributions for IRAs in 2016 is $5,500, or $6,500 if you’re age 50 or older. IRAs typically contain a combination of investments in stocks, mutual funds, and bonds. All this is true for both traditional and Roth IRAs.
There are a lot of benefits to having IRAs, but most American’s still don’t utilize them. As recently as 2010, 75% of Americans nearing retirement age had less than $30,000 in retirement accounts. Forbes Magazine shared this statistic and called it "the greatest retirement crisis in American history.” $30,000 may sound like a lot of money, but it isn’t when you have to live off that money for the rest of your life. There are several factors that likely contributed to these relatively small retirement account numbers. Factors include low savings rates, the recent housing and financial crises, and poor stock market performance the preceding couple of years. But the reality is that people just didn’t make saving for retirement a priority.
Now let’s breakdown the differences between these two types of IRAs and look at each type of account separately.
The Traditional IRA
Traditional IRAs were established in the U.S. with the Employee Retirement Income Security Act of 1974.
The primary benefits of a traditional IRA is that the money you contribute is tax-deductible and tax deferred. Tax-deductible meaning that if you contribute $5,500 to a traditional IRA, you will be able to subtract $5,500 from your taxable income at the end of the year. Tax-deferred meaning you are deferring or delaying paying taxes on that money. With tax-deferred accounts you pay no taxes on the money up-front but you will have to pay taxes when you withdraw money from the account.
Whenever you decide to withdraw money from your account, all of that money will count as taxable income which could potentially put you into a higher tax bracket for that year. But IRAs are intended to be used after you reach retirement age. Because you will be retired you likely don’t have a full time job so your income is going to be lower than it is currently. Because you have a lower amount of annual income you will be in a lower tax bracket. But when you do withdraw money from a traditional IRA is does count as taxable income and you will have to pay taxes on the money you take out from the IRA account. Just something to keep in mind.
In addition to any withdrawals from the account being included as taxable income, if you are under age 59½ when you withdraw money, then the IRS will also assess a 10% early withdrawal penalty. There some rare exceptions that the IRS will waive this penalty but don’t plan on it. Basically, don’t plan on using money in your IRA before the age of 59 ½ and you won’t have to worry about any penalties.
Also, with a traditional IRA you MUST start making withdrawals by age 70½. If you fail to make at least the minimum required withdrawal, then half of the mandatory amount will be automatically taken by the IRS. So plan accordingly and don’t let the IRA take your money.
The Roth IRA
The Roth IRA was established by the Taxpayer Relief Act of 1997 and named after its sponsor, Senator William Roth of Delaware.
The Roth IRA also allows individuals to invest money in a retirement account but there are no immediate tax deductions with this type of account. This means that the money you put into a Roth IRA account is counted as income for tax purposes the year the income is earned. You will have to pay taxes upfront with the Roth IRA, but the kicker is that the contributions AND any future earnings both grow tax-free and can be withdrawn tax-free at retirement starting at the age of 59 ½. This means that while you pay taxes on the principal amount that you contribute to a Roth IRA in the year you earned the income, all of the interest, dividends, and growth on that money in a Roth IRA grows without ever having to pay taxes on the gains.
Another key advantage is that with a Roth IRA, you can withdraw the money you put in (your contributions) tax-free and penalty-free at any time after you have had the account for at least five years. Just to be clear, this only applies to the money you put into the Roth IRA account. If you try to withdraw any earnings above the initial contribution before age 59 ½ you will pay a 10% early withdrawal penalty.
Most other tax-deferred retirement plans, including the traditional IRA and 401(k) not only stop letting you contribute but also require withdrawals to begin when you reach age 70½. The Roth IRA does not require withdrawals or distributions at any age. You can also keep contributing to a Roth IRA after the age of 70. In fact, if the account holder doesn’t need the money he or she can let it sit and grow and even leave it to heirs or beneficiaries if they chose to do so.
As mentioned earlier, there won’t be any tax deductions when investing in a Roth IRA. So you have to pay the taxes just like all of your regular income the year that you make the contribution.
One restriction keeping people from starting or adding money to a Roth IRA is their income is too high. For 2016, the income limits for an individual is $117,000 a year and a married couple needs to be making less than $184,000 a year. The income limits affecting Roth IRA contributions tend to gradually increase each year. If you are fortunate enough to be a high income earner making above those amounts and plan to save money in an IRA you will have to save in a traditional IRA.
Here is a table to act as a quick recap:
A Roth IRA is better if you think your earnings in future years will go way up from your current level. If you do have higher earnings and income later in life, it’s likely that a lot of your retirement savings will also come later in life so that you maintain a standard of living in retirement that’s higher than what you have now. If you think you will need a lot of money in retirement, it’ll be very useful to have some money available that is tax-free, especially if the income tax rates continue to climb.
The Roth IRA is the most flexible account. There are no tax penalties for withdrawing contributions early, all growth from earnings and dividends will continue to grow tax-free, and there’s also no requirement to begin withdrawing at age 70.
However, if you are a high-income earner and expect your income to be significantly less in retirement than it is now, a traditional IRA may be the best approach. Also, if you do decide to go with a traditional IRA you can always convert the account to a Roth IRA. But you cannot go from a Roth to a traditional IRA.
Lots of Options
The above two IRA options will be good for a large majority of people. But similar to most other investment options, IRAs can very complex. There are SEP IRAs, SIMPLE IRAs, Backdoor Roth IRAs, Rollover IRAs, self-directed IRAs, 401(k) to IRA conversions, traditional IRA to Roth IRA conversions, etc. Each of these have their own set of rules and requirements. I’d be glad to answer questions on them or at least provide additional resources if anyone is interested. Those of you who are self-employed or have your own businesses on the side really do have a lot more options.
As Asher Roth said in his hit song:
“I can’t tell you what I learned from school,
But I could tell you a story or two,
And yeah of course I learned some rules…
Man I love college.”
To add a few more lines:
I wished I learned more about money in school,
But instead I lived off a credit card like a fool,
I always spent more money than I had in the bank,
That explains why my credit score just sank.
It may be hard to believe but I’ll probably put my song writing career on hold and stick to writing about money J. Despite having to suffer through those last few sentences, there is no time like the present to save more, learn more, and earn more.
Action Item for Today
Determine which type of IRA will benefit you the most, likely that is a Roth IRA. You can’t really go wrong with either one. As long as you are savings money then you are doing great. But you should figure out which type of IRA will work best for you so you can optimize your savings so you will end up with more money in the long run.
My next article will walk you through how to open an IRA. Once you open a Roth IRA be sure to set up monthly automatic transfers from your bank account to your new Roth IRA account. You won’t even miss that money it will grow way faster than you think.