Roth vs. Traditional IRA
What’s the difference between a Roth vs. Traditional IRA? And why do you need one?
This is a common question I get in my line of work. After all, everybody wants to know the “fast track” to wealth and retirement. Before we dive into the technical stuff, though, please take a look at my page on money shame. You may also benefit from taking the money quiz to understand your unique money profile.
There is a simple and powerful reason for taking these steps now: If you haven’t done the work to overcome money shame first, no amount of tactical maneuvering with your financial portfolio can save you from yourself.
Yes, I know that’s a bit heavy to kick things off – but having coached thousands of clients over the years now, I can tell you with absolute certainty this is the correct move order. Uncover your money shame first, then dive into the details of financial planning. Otherwise, you may make a perfect IRA decision but struggle to make contributions. Alternatively, you may run into other challenges that make your long-term financial plan difficult to achieve.
This is something I don’t always highlight in my regular articles, but every now and again it’s important to bring back to the forefront. This is where the hard work is done; where the foundation is laid from which you can truly grow. Get this one thing right, and you will become unstoppable!
Okay, now that we have all of that out there… let’s dive into the technical details of Roth vs. Traditional IRA accounts.
Saving For Retirement: Now or Later?
It’s easy to put off saving for retirement because we know it’s important. We want to get it right, but we’re not always sure where to start.
When you are struggling with weekly expenses, retirement seems far away. If you are digging out of debt, it may feel like you don’t have anything to spare.
In many cases, you need to prioritize paying down debt, but as soon as you can set aside money, retirement should be a top priority. The most important part of saving for retirement is that you start as early as you can. The details of how much you invest and where you invest it is not as important as the amount of time your nest egg is given to grow.
An IRA (Individual Retirement Account) is simple to set up and you can do it yourself, regardless of whether your employer offers a retirement plan or not. One of your first decisions is whether you want a Traditional or Roth IRA.
Let’s start with what Traditional and Roth IRAs have in common.
Deposits must be made with earned income. This means the money cannot come from a rental property or child support, for example. If you are married but only one of you works, you can open a spousal IRA for the non-working spouse as long as your household income is greater than or equal to the total contributed.
Funds are set up in one person’s name, and for 2020 the annual contribution to an IRA is capped at $6000 per individual, or $7000 after age 50. An individual can open more than one fund—for example, one person can have a Roth and a traditional IRA. The contribution limit is for the combined amount paid to both funds. Contributing more than $6000 could result in penalties assessed annually until you correct the amount in your fund.
A saver’s credit is available to those with lower incomes, which can greatly offset your contributions with tax credit. It is a sliding scale, with the biggest return to those making under $39K filing jointly, but benefiting those with household income up to $65K. Remember, a tax credit directly lowers what you owe in taxes. Not to be confused with deductions which lower your taxable income. But if you fall within a lower income bracket, you could get as much as half of your IRA contribution back in tax credit.
While both types of IRA allow your money to grow tax free during your working years, the main differences are when you pay tax on the money, income limits, and when you have to start drawing on those accounts. You may choose one over the other if you anticipate your tax bracket to be much higher now or in retirement.
The after-tax income used to fund a Roth IRA grows tax-deferred and is withdrawn tax-free in retirement. Many people assume their tax bracket will be lower when they stop working.
When you retire, your paid wages may be lower, but consider payments you will have from social security, pensions, and annuities. Many people take on freelance or contracting work in retirement, even if they no longer work for a big company 9 to 5. Also, you may have fewer deductions later in life from things like mortgage interest and student loan interest that would make your earned income higher than you may expect.
A Roth IRA is only available to those within certain income limits based on your modified adjusted gross income (MAGI). This number is your adjusted gross income plus tax exempt interest income and some deductions added back.
For 2020, marrieds filing jointly making less than $196,000 or single filers with $124,000 MAGI qualify for an account.
You are never required to take distributions from a Roth IRA, making it a great vehicle for wealth transfer. Your beneficiary does not pay tax on the money either, but they do have to take a distribution or convert it to a qualifying IRA in their name upon transfer.
Also, you have more flexibility to access your money in a Roth IRA.
With a Roth, as long as you have held the account for 5 years, you can take money out and only pay penalties on the earnings. Even those withdrawals are penalty free for certain life events, such as to help pay for an adoption, a first time home purchase, or again, medical expenses during hardship.
Contributions to a traditional IRA are pre-tax dollars and are deductible in the year they are made both for state and federal taxes. Lower taxable income may help you qualify for other deductions if you are close to the threshold, such as a child tax credit you would not have qualified for at the higher income.
Anyone under the age of 70 ½ can contribute to a traditional IRA as long as they have qualifying earned income. If you also contribute to an employee retirement fund such as a 401K, you may not get the full amount as a deduction, but the money you invest still grows tax deferred.
However, when you reach 70 ½, you are required to start taking distributions from a traditional IRA whether you need them or not.
In addition to taxes, taking money out of a traditional IRA before age 59 ½ will cost you a 10% penalty, with certain exceptions such as paying medical premiums after a job loss. The CARES act waves the 10% penalty on distributions from your IRA due to economic hardship from families affected directly by COVID-19.
Making the choice between a Roth and Traditional IRA
As you can see, there are benefits both ways! Traditional IRA contributions are tax-deductible, which can lower your taxable income and get more money into your retirement accounts today. However… there are stiff penalties for early withdrawal, you are eventually forced to take distributions, and you’ll pay taxes on the money later.
On the other hand, Roth IRA contributions are made with after-tax money. This means 100% of the money in your Roth IRA account is yours to keep, plus it will grow tax free over all the years it’s in there! As we have discussed, Roth IRAs are also a bit more flexible than Traditional IRAs, and they can function as excellent wealth transfer vehicles.
For that matter, I would recommend everyone setup a Roth IRA at a minimum – but it’s perfectly acceptable to choose a Traditional IRA instead, or even to open and maintain both types of accounts (Roth & Traditional IRA). During any given year, you can split your total IRA contributions between them and reap the benefits of both. The only thing you cannot do is make a maximum contribution to each – you always have to make sure the total of all IRA contributions is no more than the max allowed. You can read more about these concepts here.
A Word about Dipping into Retirement
Before we close this article out, an important note on dipping into your IRA account(s).
Notably, you should never set up an IRA as a short-term emergency fund. Borrowing from a retirement account like an IRA should only be considered under the most dire circumstances. Early withdrawals from your retirement savings, especially during tough economic times, puts a great risk to your financial recovery. While you may not see much happening in that account, protecting your IRA should be a priority. Untouched money has a chance to recover as the market recovers, and this growth is what will bolster your savings.
Even when times are tough, you likely have more options to make money now than you will in your 80’s. Unless you have a trust fund headed your way, no one else is going to help you fund the last years of your life.