Sooner or later, we’re all going to need to pick a retirement savings account. And if you’ve decided an IRA (individual retirement account) is right for you, you’ve got yet another choice to make: Should you open a Roth or traditional IRA?
Well, I can answer that question with another question: Do you think you’ll be at a higher tax rate just before you retire?
If your answer is “Yes,” you’re likely better off with a Roth IRA. (I’ll explain why in just a minute.)
However, there are some other big differences when it comes to Roth versus traditional IRAs and the benefits they provide. So before you dive right in and open an account, let’s compare these two IRA types and determine which one is the best fit for your needs.
Traditional IRAs vs. Roth IRAs
Let’s use a table to lay out the differences and similarities between traditional and Roth IRAs.
|Traditional IRA||Roth IRA|
|Maximum Contribution Amount for 2020||$6,000, or $7,000 if you are 50 or older||$6,000, or $7,000 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and tax-deductible contributions will be taxable upon withdrawal||Both contributions and investment earnings can be withdrawn tax free|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|
|Income Limits — Single||No limit if no employer plan. If you do have an employer plan, full deduction up to $64,000, gradually phased out up to $74,000. Can make a nondeductible contribution above $74,000||Full contribution up to $122,000, gradually phased out up to $137,000. No contribution permitted on income above $137,000|
|Income Limits — Married Filing Jointly||No limit if no employer plan. If you do have an employer plan, full deduction up to $103,000, gradually phased out up to $123,000. Can make a nondeductible contribution above $121,000||Full contribution up to $193,000, gradually phased out on income up to $203,000. No contribution permitted on income above $203,000|
|Income Limits — Married Filing Separately||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 nondeductible contribution above $10,000||Partial contribution up to $10,000 income. No contribution permitted on income above $10,000|
As you can see, the simple answer depends on whether or not you think you’ll be making more money in the years leading up to retirement. That’s all of us, unless you’re a total pessimist, right?
Because Roth IRA withdrawals are generally tax free, you won’t have to pay hefty IRS bills when it’s time to start drawing your money.
On the other hand, if you choose a traditional IRA, you’ll take advantage of the tax deduction now.
But that’s not the only factor that can go into your decision when it comes down to traditional versus Roth.
Let’s break it all down so you can determine in which scenario each IRA type makes more sense.
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, 24% 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 2020, singles can earn up to $64,000 per year and still deduct the full amount of the contribution. The deduction phases out between $64,000 and $74,000, after which none of it will be deductible.
If you’re married filing jointly, you can earn up to $103,000 and still deduct the full amount of the contribution. The deduction phases out between $103,000 and $123,000, 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 nondeductible 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 nondeductible 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.
(Note: There is a way to still contribute to a Roth even if you’ve exceeded the income limits. You’ll just have to take the “back door.”)
When a Roth IRA Makes More Sense
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 may not make sense if you have no income tax liability or if you’re in the 10%, 12% or 22% 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 and penalties, 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 may need the money before retirement, the Roth IRA should be your choice.
A Third Option
Even 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.
If both seem applicable to your potential situation, there is a third option: You can hedge your bets and maintain both a traditional IRA and a Roth IRA. For example, you could contribute $3,000 to each, or $4,000 to one and $2,000 to the other. (And of course, the total is greater if you're age 50 or over.) That way, you’ll be prepared for whatever tax situations come your way.