The type of individual retirement plan you choose today can have a major impact on your future savings and future tax liability. Deciding between a Traditional IRA and a Roth IRA is not as simple as flipping a coin; choosing between one of the two will mean either paying tax today or paying tax down the road. To decide which one is right for you this article will detail the difference between the two.
The purpose of both a Traditional IRA and a Roth IRA is to incentivize taxpayers to save for retirement. The tax savings for both are substantial with the difference being the timing of the tax destructibility. Traditional IRA contributions are tax deductible when you make the contribution while the Roth IRA contributions cannot be deducted. However, Roth IRA distributions are generally tax-free.
A traditional IRA is a individual retirement plan that allows your earnings to grow tax deferred. This means that you won’t pay taxes on your yearly income and capital gains until you make a distribution from the retirement account.
If you’re not covered by an employer sponsored retirement plan then you can deduct your total contributions (up to $5,500 annually or $6,500 if you’re 50 or older). If you are covered under an employer sponsored retirement plan then the deductibility of your contributions will be subject to income limitations.
Traditional IRAs are great for taxpayers who want to defer tax until retirement and reap all the tax benefits upfront. The extra tax savings can be reinvested into the retirement account and compound over several years. However, some taxpayers might find it beneficial to chose a Roth IRA based on their retirement needs.
Contributions to a Roth IRA are nondeductible but the earnings in a Roth IRA can grow tax free. The tax benefit of a Roth IRA comes in retirement in the form of tax free distributions. Additionally, since contributions to a Roth IRA are after tax contributions the taxpayers can withdraw their contributions, not the earnings, tax free and penalty free.
However, not all taxpayers are eligible to contribute to a Roth IRA. The IRS sets income limitations which disallow high income taxpayers from contributing to a Roth IRA directly.
It makes sense to contribute to a Roth IRA if you expect your future earnings to be higher in retirement. This makes a Roth IRA a perfect retirement vehicle for young, lower income workers who won’t get much of a tax benefit from traditional IRA contributions.
Roth IRAs are also great for taxpayers who don’t want to be subject to minimum distribution requirements. Required minimum distribution is the minimum amount you must withdraw from your account each year. You generally have to start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 70½. However, Roth IRAs do not require withdrawals until after the death of the owner. This works well for high income taxpayers who want to leave
Backdoor Roth IRA
For taxpayers who exceed the income limitations to contribute directly to a Roth IRA there is a way to get funds into a Roth IRA legally. The most common method is contributing to a traditional IRA and then rolling over partial amounts or even the entire portfolio into a Roth IRA.
However, when you roll over any amount from a traditional IRA that was previously deducted for tax purposes you will be subject to income tax on the portion that was deducted. For example, if you have $50,000 in a traditional IRA that was fully deductible then you will pay taxes on $50,000 if the entire amount is rolled over into a Roth IRA.
Rolling over into a Roth IRA is great for taxpayers who have gap years where income is substantially lower than previous years. The taxpayer can benefit from the low tax rate and withdraw income in later years when their tax rates would otherwise be higher.
Choosing the right retirement account can be difficult and often times confusing. Not all retirement plans are one size fits all and may work in specific circumstances; what might work for one taxpayer may not necessarily work for another. Traditional and Roth IRAs my be great tax savers if used effectively but it is important to discuss with your financial adviser before choosing the right one for your retirement needs.