Whether you’re a new college graduate or an established professional, it’s never too early to start saving for your retirement. As one might expect, the longer you live, the more resources you’ll need to sustain your lifestyle, so it’s always a good idea to start saving sooner rather than later.
When saving money for your retirement, there are two common types of individual retirement accounts (IRA) that you can invest in: a Roth IRA and a traditional IRA. When reviewing some of their key differences, it’s important to ask yourself: “When is the most advantageous time to pay tax on my income?”
Key Differences Between a Roth IRA and a Traditional IRA
You may think the term “Roth” is an acronym for a complex financial term, but that’s surprisingly not the case. The origin of “Roth” derived from a person, William Roth, who was a Delaware senator when the Roth IRA was established by the Taxpayer Relief Act in 1997. When beginning the decision-making process, it’s important to determine how you prefer your contributions to be made. Never deductible, the contributions you make to your Roth IRA use after-tax dollars, which in turn affects the amount of investment income you will make.
In regard to a Roth IRA’s tax implications, consider whether or not you think your tax rate during your retirement will be higher or lower than your current tax rate. With a Roth IRA, you’re able to pay taxes sooner rather than later when compared to a traditional IRA, and you’ll receive distributions that are free of taxes once your income tax rate reaches a certain percentage.1
If you’re concerned about when you’ll be able to take money out of your individual retirement account, there are rules for required minimum distributions (RMD) that Roth IRAs are not subject to currently. This may make the Roth IRA more appealing to those who do not want to be required to distribute their retirement assets before they’re ready.
However, not everyone is able to fund a Roth IRA due to their joint household income exceeding $196,000 for 2020. If that's the case, you may still consider making a non-deductible IRA contribution and then convert to a Roth IRA, aka a Backdoor Roth IRA contribution. The drawback is that if you have a Rollover IRA from a previous employer, the Roth Conversion piece may not work for you in which case you can still make the non-deductible (after-tax) contribution and leave the funds invested. Just the earnings will be taxable in retirement.
Weighing Your Options
While Roth IRAs and traditional IRAs share similarities, such as being a way to save and invest your money, one of the key differences between the two retirement vehicles surrounds eligibility. Unlike a Roth IRA, your ability to deduct contributions from your traditional IRA depends on detailed requirements that are important to explore and consider before making your decision.
As long as you don’t contribute to a retirement plan offered by your employer (or even if you do, but your annual income is less than $76,000 if single or $125,000 if married filing joint), your traditional IRA is fully tax-deductible,2 while contributions to Roth IRAs are not. However, because you make contributions before paying any taxes, your distributions are treated as income, and could, therefore, lead to higher income taxes later on.
You may also consider a Spousal IRA for a stay-at-home parent to fund their retirement. As long as one person in your household earns a paycheck and you file a joint tax return, the stay at home spouse may be able to contribute to an IRA without earning an income.3
For people who are eager to withdraw their contributions, it’s important to note that you may be subject to a penalty if you withdraw any money before you are 59½. Because you’re required to withdraw these funds the year after you’re 72 (if you have not already reached age 70½ by the end of 2019), you will need to steadily reduce your balance and list the distribution amount as part of your income during tax filing season.4 This could be a deal-breaker for those who would like to contribute to their savings plan with no limits or restrictions, especially since Roth IRAs do not have an age limit.
Education is Key
When it comes to choosing between a Roth IRA and a traditional IRA, there is no right answer. Everyone is going to have a different preference depending on when they want to pay their taxes, how much they plan to withdraw in retirement, and whether their tax bracket is higher or lower now than where they expect it to be in retirement. However, it’s important to compare the pros and cons of each before making a decision if you want to make the optimal choice for you and your family.
Preparing for your retirement may seem like a daunting task, but deciding which retirement plan suits your needs the best is the first step to securing your assets, future and well-being for the coming years. Whichever decision you make, it’s important to understand that our needs are constantly changing, so be sure to not only think about your current preference but also revisit the decision in later years to determine whether changes are needed down the road.
Investment Advisory Services offered through EnRich Financial Partners LLC, a Registered Investment Advisor.
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