Many people wonder which IRA is best suited for them. Should you stick with the Traditional IRA or go ahead with Roth IRA? In certain cases, it’s easy to decide. For example, the Roth IRA becomes your obvious choice if you are ineligible for a Traditional IRA due to income levels or an employer-provided retirement plan. But how do you decide when you do have a choice?
Well, both IRA options offer significant tax advantages, but one might be more suitable than the other based on your income level, age, and needs. They differ primarily in the way your contributions are taxed. Let’s analyze both traditional and ROTH IRAs before you decide which one is right for you.
The contributions you make to a Traditional IRA are tax-deductible in that year. For example, if you contribute $5,000 to a Traditional IRA, you can deduct $5,000 from your current taxable income. However, the withdrawals you make after retirement will be taxed as part of your ordinary income. This is especially beneficial for people who are in higher tax brackets at present, but expect to be in a lower tax bracket after retirement.
A potential downside of the Traditional IRA is that it requires you to start taking minimum distributions at age 70 ½, even if you don’t need the money, and there are stiff penalties if you don’t withdraw at least the required minimum distribution every year. Additionally, if you need to withdraw money before the age of 59 ½, there will be an early withdrawal penalty along with the taxes.
If you have a high income and expect your income to drop in retirement, a Traditional IRA may be the right choice in saving money for retirement. Why? well it’s simple.. You’re putting money in at a high tax bracket and pulling money out at a lower tax bracket. Also a Traditional IRA doesn’t have any income restrictions, and your contributions can be invested in almost anything.
A Roth IRA is completely opposite of Traditional IRA in the way taxes are levied. With a Roth IRA, the contributions you make will not be tax-deductible in the same year, i.e., you have to pay taxes on the contributions you make in a particular year. However, when you start withdrawing money after retirement, the distributions will be tax free. This is advantageous especially for people who anticipate being in higher tax bracket after retirement.
To qualify for Roth IRA, your modified adjusted gross income (MAGI) should be less than $122,000 if you are single. The limit for married tax filers is $179,000.
It is not mandatory with a Roth IRA to start taking the required distributions upon reaching age 70 ½. If you already have a Traditional IRA, Pension Plan or employer-sponsored retirement plan such as a 401(k), you can still contribute to Roth IRA within certain income levels.
Besides these benefits, the Roth IRA has very simple rules for withdrawals. It allows you to withdraw the contributions (not gains) before 59 ½ without any penalty or taxes. You’re allowed to withdraw earnings federally tax-free after the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first-time home purchase. In case you withdraw for any other purpose, you have to pay a 10 percent early withdrawal fee.
Have a Combination of Both if Possible
No kidding. You don’t know what the tax rate would be after two or three decades, so it is safe to multiply your sources of retirement savings. If you diversify your tax liabilities, you will be better prepared for any major tax rate changes by the time you retire. Try to reach the maximum on both Traditional as well as Roth IRA contributions.
Diversification provides another benefit. This way you can prevent falling into higher tax bracket upon retirement. If the income from a Traditional IRA and other sources push you into higher tax bracket, you have the option to lower the Traditional IRA withdrawal rate and take out from the Roth IRA, which is tax-free in retirement.
What type of IRA do you have? Why did you pick that one? If you don’t have an IRA what are you doing to save for retirement?