Author: Ryan Kimes, CFP®
“IRA” is a commonly used acronym for “Individual Retirement Account”. These types of legal accounts are given special tax treatment to incentive individuals to save for retirement. The type of IRA you invest in can significantly impact your long-term savings, so it’s crucial for investors to understand the differences and advantages of these accounts.
Limited Annual Contributions
Many individuals struggle to take the initiative when opening a retirement account, a mistake that can often lead to missed tax-year contribution opportunities. Both Roth and Traditional IRA contributions are limited to $5,500 per year, or $6,500 if age 50 or older. This means that you are limited to the amount of principal that can be invested in the account each year, with the deadline for the previous year being April 15th, tax day. For example, if in 2018 you contribute $250 per month in 2018 ($3,000 by December 31st, 2018), you will have until April 15th, 2019 to contribute the remaining $2,500 for the 2018 tax-year. If the contribution is not made by April 15th, 2019 (tax-day), the $2,500 of remaining contributions will be missed and cannot be made up for in future years. Why does this matter? Because the long-term impact of these account’s tax-advantaged provisions on your net investment are substantial, and income phase-outs can further limit future contribution opportunities.
The tax-savings characteristics of Roth and Traditional IRAs differ significantly, so selecting the proper account contribution should be a priority for investors. To start, Traditional IRAs are considered pre-tax contributions. This means any amount invested in the account will not be taxed, providing an end-of-year tax credit to the individual. For example, if an individual who is making $50,000 per year, within a 20% hypothetical tax bracket, contributes $5,000 in a given tax-year, he will only be taxed on $45,000 of income that year. Why is this important? Instead of being taxed 20% on the $5,000 of income invested, netting $4,000 in after-tax dollars, the initial investment in the Traditional IRA will be the entire $5,000 of pre-tax dollars. The long-term compounding on the initial investment will immediately be at an advantage within the traditional IRA. Further, investment capital gains and investment income will be deferred until withdrawal from the account, rather than being taxed each year as with a regular taxable investment account. With taxation being deferred annually, the dividend income and capital gains that would have been lost to taxation remains within the account, continually compounding until withdrawal. However, when the retiree begins to make withdrawals from his Traditional IRA, the full amount of the withdrawal will be subject to income taxes.
Alternatively, Roth IRA funds are deposited after taxes are taken out of the individual’s annual income. Instead of providing tax deferral for dividend income and capital gains, as with Traditional IRAs, earnings within Roth IRAs are tax-free when withdrawn in a qualified manner. Qualified withdrawals include: earnings withdrawals after age 59.5, first time home-purchases (lifetime maximum of $10,000), post-secondary education expenses, certain medical expenses, IRS tax-levies, and health insurance premiums in certain situations. For all qualified withdrawals, the Roth IRA must have been established longer than five years prior to withdrawal.
Other Withdrawal Rules
Another difference to consider when selecting between Traditional and Roth IRA contributions is when the savings must be withdrawn. It is important to remember that a 10% early withdrawal penalty may be imposed by the IRS for Traditional IRA withdrawals before age 59.5. Due to this Traditional IRA early-withdrawal penalty, Roth IRAs are better for those who wish to have access to the funds prior to retirement. So long as the account has been open for five years, contributions to Roth IRAs may be withdrawn without penalty. Again, this no-penalty withdrawal is applied to contributions only, not earnings. Withdrawals of earnings may be penalized if they are not qualified. As previously discussed, for Roth IRA earnings to be withdrawn tax-free before retirement, certain conditions must be met
With Traditional IRAs, you must begin withdrawing what are called required minimum distributions (RMDs), by age 70.5 years old, whether you need the withdrawals or not. This requirement is in place so deferred taxes within Traditional IRAs are eventually realized by the Federal Government. Otherwise, the pre-taxed dollars within Traditional IRAs could remain in the account and potentially grow indefinitely without taxation, should the funds never be used.
However, with Roth IRAs, withdrawals are never required unless in the case of an inherited Roth IRA. If you do not need income from your Roth IRA, you may allow it to continue growing tax-free through the remainder of your life, making them excellent wealth-transfer accounts.
Roth IRA: Single tax filers may make contributions to Roth IRAs with modified adjusted gross income less than $135,000 (contribution maximum begins phaseout at $120,000). Married individuals filing jointly have a phaseout range of $189,000-$199,000.
If you anticipate a higher income in coming years, it is crucial to take advantage of eligible contribution years. They will likely be limited.
Traditional IRA: All tax-filers may contribute to a Traditional IRA, but tax deductibility rules are based on an individual's income and access to employer retirement plans.
Which Is Right For You?
To determine the best long-term choice for your contribution, you must consider whether your tax-rate for the current year will be greater today or tomorrow. Of course, you cannot predict what the federal income or state tax rates will be in 30 years, but you may anticipate more or less income on any given tax-year.
Generally speaking, you want to realize taxation by contributing to a Roth IRA in years where your modified adjusted gross income will be less than in future years. Though it is common for individuals to anticipate making less in retirement, lost tax deductions, credits, and increased passive and social security income, often places retirees at a higher adjusted gross income in retirement. In this scenario, a Roth IRA contribution would be the superior choice over a Traditional IRA contribution.