Even though Roth IRAs and traditional IRAs are both Individual Retirement Accounts, there are significant differences in the details of each. Before opening a new account to take advantage of year-end tax savings, you’ll want to compare the differences and know how to decide which is the best fit for you.
Traditional and Roth IRAs — The Basics
Before getting into which plan is the best one to open, here’s a summary of the basic features of each.
Traditional IRAs have the following provisions:
- Contributions are tax deductible when made, up to certain income limits (see below).
- Investment earnings accumulate on a tax-deferred basis.
- Withdrawal of both contributions and investment earnings are taxable and added to other taxable income.
- There’s a 10% early withdrawal penalty — in addition to applicable income tax rates — on withdrawals taken before turning 59½.
Roth IRAs have the following provisions:
- There are no tax deductions on the contributions made to the plan.
- Investment earnings accumulate on a tax-deferred basis.
- Withdrawals of both contributions and investment earnings are tax free if taken after age 59½ and the plan has been in existence for at least five years.
- Contributions taken before age 59½ can be withdrawn tax free (and penalty free), since there was no tax deduction taken when they were made. Withdrawal of investment earnings are subject to regular income tax, plus the 10% early withdrawal penalty, if taken before 59½.
Under both plans you can contribute up to $5,500 per year per taxpayer, or $6,500 per year per taxpayer if you are age 50 or older (as of 2016).
When a Traditional IRA Makes More Sense
When determining whether a Traditional or Roth IRA is the best choice, consider these facts for when a Traditional IRA makes more sense.
When you have no other retirement plan — If you have no other retirement plan, then your contributions to a traditional IRA will be fully tax deductible, regardless of income. This is especially beneficial if you are in the higher income tax brackets, say, 25% or higher.
When the IRA is tax deductible, even if you’re covered by another plan — Even if you’re covered by another retirement plan, you can still deduct a traditional IRA contribution if your income does not exceed certain limits. For 2016, singles can earn up to $61,000 per year and still deduct the full amount of the contribution. The deduction phases out between $61,000 and $71,000, after which none of it will be deductible.
If you’re married filing jointly, you can earn up to $98,000 and still deduct the full amount of the contribution. The deduction phases out between $98,000 and $118,000, after which none of it will be deductible.
When your income exceeds the limits for a Roth IRA — With a traditional IRA you can make a non-deductible contribution even if your income exceeds the income limits. But when it comes to a Roth IRA, once you reach the income limits, you can’t make a Roth contribution at all.
In that situation, it makes sense to make a non-deductible contribution to a traditional IRA. It will increase your retirement funding overall and still allow your investment income to accumulate on a tax-deferred basis.
When a Roth IRA Makes More Sense
When determining which type of IRA is the best choice, consider these facts for when a Roth IRA makes more sense.
If your income exceeds the thresholds for deductibility of a traditional IRA — If you are covered by a retirement plan, the income thresholds are higher for Roth IRAs than for traditional IRAs. You can make a Roth IRA contribution if you are single and your income exceeds $61,000 (the traditional IRA income limit), or you are married filing joint and your income exceeds $98,000.
For 2016, Roth IRA income limits are: for singles: $117,000 (full contribution), then phased out up to $132,000; for married filing jointly, $184,000 (full contribution), then phased out up to $194,000.
When you’re interested in creating tax diversification within your retirement plans — Traditional IRAs are tax deferred with respect to both contributions and accumulated investment earnings. Roth IRAs, however, are tax free if you are at least 59½ at the time you make the withdrawals and the plan has been in existence for at least five years.
In this way Roth IRAs provide you with income tax diversification. While distributions from other retirement plans become taxable upon withdrawal, your Roth IRA funds come to you completely free from federal income taxes. It’s an excellent strategy, especially if you will continue to be in a relatively high marginal income tax bracket in retirement.
When you want to preserve your money past age 70½ — We’re talking about required minimum distributions (RMDs) here. They kick in at age 70½ and they apply to virtually every retirement plan except for the Roth IRA. Simply put, once you reach that age, you’re required to begin taking distributions based on your remaining life expectancy.
Since Roth IRAs have no RMDs, you can build your investment virtually for the rest of your life. This is an excellent way to continue accumulating retirement assets so that you don’t outlive your money. It’s also an excellent way of preserving more of your estate to pass on to your heirs. Only a Roth IRA can do that for you.
If your income tax liability is either low or nonexistent — Even if you can make a deductible traditional IRA contribution, it might not make sense if you have no income tax liability or if you’re in the 10% or 15% marginal tax rate bracket. Since Roth IRA money can be withdrawn completely free from income taxes, it is a superior retirement plan to a traditional IRA. The last thing that you should want to do is trade a 10% tax savings now for a potentially higher tax rate on withdrawals in retirement, which is exactly what you’ll do if you make a contribution to a traditional IRA.
If you think you may need access to the money before retirement — Since there is no tax deduction from making a Roth IRA contribution, the amount of the contribution can be withdrawn free from income taxes, even if the withdrawal happens before you turn 59½. Not so with a traditional IRA if the contributions were tax deductible when made. So if you think you might need the money before retirement, the Roth IRA should be your choice.
Though they’re both IRAs they have so many different provisions that how and when you use them will also be different. So before opening a new account or creating a new retirement plan, consider both types and their effects.
The IRA X Factor — Trying to Predict Your Future Tax Situation
Though many investors concentrate primarily on maximizing tax savings in the present — which usually favors a tax-deductible traditional IRA — a more important consideration is your future tax situation. After all, traditional IRAs are merely tax deferred, which means that you’ll have to pay taxes on the funds when they are withdrawn. That will increase your taxable income when you retire.
Roth IRAs, on the other hand, can be withdrawn completely tax free in retirement. For that reason you should favor a Roth IRA if for any reason you believe you will have a substantial tax liability when you retire.
There’s no way to know with absolute certainty what your tax liability will be when you retire, but there are clues that can shed some light in providing a reasonable projection.
Consider the following, which are just some of the potential retirement tax situations you may face:
- Future income tax rates — Do you think tax rates will be higher or lower when you retire? If you think they will be higher, you should favor a Roth IRA.
- Your own income situation — Will you have other retirement income sources? Social Security, certainly. But how about a traditional pension plan? Non-retirement investment income? Income from rental real estate? Deferred income? Add up all of your potential retirement income sources, then compare the total with your current income. If it’s higher than your current income, a Roth IRA will work better.
- Your current income tax deductions — If a large portion of your income is reduced by itemized deductions, tax credits or other adjustments and reductions, how many of these do you expect to continue into retirement? The disappearance of some or most of these deductions would increase your taxable income, favoring a Roth IRA.
- Earned income in retirement — Do you plan to continue working into your retirement years, even on a part-time basis? Are you self-employed? If you are, you should realize that the self-employed often continue working into retirement. Factor your expected earned income into your tax situation.
- State of residence in retirement — What is the tax situation of the state you plan to retire to? If you plan move to Florida for example, as so many retirees do, you’ll be happy to know there’s no state income tax there. This would reduce your taxes and favor a traditional IRA, particularly if you currently live in a high-tax state and benefit from the current tax deductibility of your contributions.
There’s a strong element of speculation in all of these tax considerations, no doubt. For that reason, it may be best to hedge your bets and to maintain both a traditional IRA and a Roth IRA. That way you’ll be prepared for whatever tax situations might come your way.
|Traditional IRA||Roth IRA|
|Maximum Contribution Amount||$5,500, or $6,500 if you are 50 or older||$5,500, or $6,500 if you are 50 or older|
|Penalty-Free Withdrawal Age||59½||59½|
|Tax Deduction||Yes – Up to certain income levels||No|
|Taxes in Retirement||All earnings and tax-deductible contributions will be taxable upon withdrawal||Both contributions and investment earnings can be withdrawn tax free|
|Required Minimum Distributions (RMDs)||Starts at age 70½||Not Required|
|2016 Contribution Limits – Single||No limit if no employer plan. If you do have an employer plan, full deduction up to $61,000, gradually phased out up to $71,000; Can make a non-deductible contribution above $71,000||Full contribution up to $117,000; gradually phased out up to $132,000; No contribution permitted on income above $132,000|
|2016 Contribution Limits – Married Jointly||No limit if no employer plan. If you do have an employer plan, full deduction up to $98,000, gradually phased out up to $118,000; Can make a non-deductible contribution above $118,000||Full contribution up to $184,000; gradually phased out on income up to $194,000; No contribution permitted on income above $194,000|
|2016 Contribution Limits – Married Filing Separate||No limit if no employer plan. If you do have an employer plan, partial deduction up to $10,000 income, phased out completely at $10,000; Can make a non-deductible contribution above $10,000||Partial contribution up to $10,000 income; No contribution permitted on income above $10,000|