Most people who are saving for retirement are faced with the question of whether to go with a Traditional or Roth IRA (which may be a supplement to a 401(k) plan). In this article we are going to review the differences between Traditional and Roth IRA deals, eligibility requirements, contribution limits, and which may be the better choice for you.
Differences between Traditional vs. Roth IRA
The primary difference between traditional and Roth IRAs are when you will receive the tax benefit of saving for retirement. With the traditional IRA you will receive the benefit immediately – that is, if you contribute in 2018, you will receive tax relief in 2018. Essentially, you are deferring your taxes until you withdraw the funds.
With the Roth IRA you will pay taxes up front (i.e., when you make the money initially), but you will not pay taxes on the funds when you withdraw them.
In theory, which you choose depends on a simple question: Do you think your tax rate will be higher when you retire than it is now. Unfortunately, this is a difficult question because it not only depends on what your current tax rate is, but it also depends on what government tax policies will be in the future.
For example, if you are in the high tax bracket now due to good earnings, you may think that you have an easy choice in going with a traditional IRA to get some immediate relief. However, if taxes were to go towards a Scandinavian-like rate once you retire this would mean paying much higher rates on withdrawal.
Eligibility and Contribution Limits
The IRS sets the rules for who can put money in and how much money they can put in. For Roth IRAs in 2018/2019 you are not eligible if:
- You make more than $199k/$203k and are married filing jointly. If you make above $189k/193k your contribution is reduced.
- You make more than $135k/$137k and file as single or head of household. If you make more than $120k/122k you contribution limit is reduced.
Contribution limits are $5,500/$6,500 if you are under/over 50. The contribution limits increase to $6k/$7k in 2019.
For a traditional IRA your eligibility for married filing jointly is the same, but for single/head of household filers the eligibility stops at $73/74k and starts to reduce at $63/$64k for 2018/2019.
So, in summary, if you are very well paid you may not qualify for either – in which case you should congratulate yourself on a job well done and you should focus on your 401(k) instead.
Choosing Traditional vs. Roth
There are many benefits to Roth IRAs that are not strictly financial (although these are always subject to change). The benefits include:
- Early withdrawal is a lot less onerous with a Roth. Although we hope you leave your retirement accounts until retirement you can get to this money easier without penalty or income tax. With a traditional IRA you are subject to a 10% penalty plus taxes.
- Roth IRAs have few restrictions with respect to required minimum distributions. The traditional IRA requires you take out a certain amount once you high 70.5 years old.
- Roth IRAs allow you to continue to contribute at any age, but traditional IRAs don’t allow contributions past age 70.5.
- Roth IRAs do provide a bit of tax diversification with respect to your 401(k) as the 401(k) is taxed as a traditional IRA.
Although the bullet points above may make it sound like I am going to argue strongly for the Roth IRA the value of the immediate tax relief should not be overlooked. If you are in a 20% tax bracket in 2019 that means your tax relief on a traditional IRA will be $1200. The time-value of this means that if you can invest that $1200 in tax-savings and let it grow over the course of a lifetime, and do this every year, then you have a powerful argument for a traditional IRA.
My advice on which to choose… Drumroll please…
Go with a Roth IRA if you have ANY concerns at all about needing to access your money before retirement. The penalties for early withdrawal mean that you absolutely need to be certain you will never need to touch that money before you can sign onto a traditional IRA.
Furthermore, tax rates are now at historical lows, and although they could go lower, there is a very good chance they could need to be much higher when you look at the debt levels and current government deficits. As I mentioned earlier, if tax rates were to go to the 50%+ rates that they are in some EU countries traditional IRAs could see a big cost in the future.
Just to wrap up, the main difference between a Roth and Traditional IRA is when you receive your tax break, with the former offering it in the future, and the latter offering it now. Roth IRAs have fewer penalties for early withdrawal, so are more advisable for savers in a more tenuous position. However, the main thing is that saving for retirement, regardless of account type is the most important thing, so it is better to contribute now, regardless of fund type, instead of putting it off.
*Important Note* It isn’t too late to make your 2018 contribution! You have until tax day (April 15, 2019) to get that 2018 donation in. So don’t let that slip past you.
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