When it comes to retirement investment choices, there are several options that may or may not be available to you – depending on income and employment status. For the most part though, US citizens have the option to invest in one of two different types of Individual Retirement Accounts: a Roth or a Traditional. The differences come down to tax treatment, eligibility, and withdrawal options.
Contributing to an IRA is without doubt a great way to save for retirement. Both traditional and Roth IRAs offer tax-advantaged growth – tax-deferred for a traditional IRA, or tax-free for a Roth IRA. Which one may be best for you, however, depends on your current and future financial circumstances. Let’s explore the options in more detail.
Why Should You Invest in a Retirement Account?
To encourage US citizens to save and invest for retirement, the tax code is set up to give benefits to those who save money in a retirement account like an IRA or a 401(k). These accounts allow money to grow without being taxed while it is growing. The result is that you keep more money that can be saved and invested.
In reality, social security retirement benefits will not cover your retirement spending needs. If you do not save and invest early and often for retirement, you may find you are not able to retire when you want to, and will likely need to work longer than you had initially planned.
Roth vs. Traditional: How to Choose
The biggest difference between a Roth IRA and a traditional IRA is how and when you get a tax break.
A Roth account is a designation that means that the money you put into the account is after-tax. Your money grows tax-free, and in retirement, withdrawals are also tax-free.
In contrast, a traditional retirement account offers a tax deduction when you make a contribution. It then grows tax-deferred, and in retirement, withdrawals are taxed at your current income tax rate.
Whether you choose, or even qualify for, a traditional IRA, Roth IRA, or both, it’s vital to understand how they work. So let’s take a look at their main differences:
- No immediate tax benefit for contributing
- Contributions can be withdrawn at any time without taxes or penalties
- Ability to contribute is phased out at higher incomes
- Qualified withdrawals in retirement are tax-free
- No age limit for contributions as long as you or your spouse have earned income
- If deductible, contributions reduce taxable income in the year they are made
- Deductions can be phased out depending on income
- Distributions in retirement are taxed as ordinary income
- At age 72, there are required minimum distributions (RMDs)
- Following the Secure Act of 2020, there is now no age limit as to when you can make contributions, as long as you (or your spouse) have earned income
Who Can Take Advantage of Roth Accounts?
Roth accounts can make a big impact on the long-term financial health of both young and old investors.
Some employer sponsored retirement plans, like a 401k or 403b, offer a Roth option inside the plan, which eliminates the need for worrying about income limits for contributions.
Here are the guidelines for investing in a Roth IRA:
- Single tax filers with a modified gross adjusted income (MAGI) less than $144,000 (with contribution phaseouts between $129,000 and $144,000)
- Married filing jointly filers with a MAGI less than $214,000 (with phaseouts beginning at $204,000)
- You must have earned income
- You can still contribute even if you’ve contributed to a traditional employer-sponsored plan
There is more flexibility for withdrawals with a Roth.
If you have a Roth account, you can withdraw the portion that you contributed over the years at any time, tax-free and penalty free.
There is a 5 year waiting period from the date of your first contribution to allow for penalty free withdrawals of the earnings portion as well.
- After five years, you can withdraw up to $10,000 to cover first-time home buyer expenses.
- There are also allowances for qualified education and hardship penalty-free withdrawals.
After the age of 59 ½, you can withdraw any portion of the account without penalty and without incurring income taxes.
The Key Benefits of Using a Roth
A Roth IRA (or Roth 401k) is a good bet for just about anyone. The ability to have tax free growth and tax free withdrawals offers a huge benefit. We are also currently in one of the lowest historical tax environments, making the tax benefits advantageous.
If you are in a lower tax bracket now than you expect to be in retirement, use a Roth. You will pay income taxes now on the money you contribute at a lower tax rate than you would in the future if you were to withdraw it from a traditional retirement account.
Having money in a Roth vehicle helps to diversify your income sources in retirement and allows for options for a thoughtful and tax-efficient withdrawal strategy for retirement income.
Younger investors have more incentive to use a Roth as they have more time to let the account grow, resulting in a larger balance from which withdrawals will not be taxed.
Advanced Planning Techniques
Custodial Roth IRA: This technique is an incredibly powerful way to set aside assets for your child and begin building generational wealth to help them get a start in life. As long as they have some earned income (through a W2 job or even self employment income like walking dogs or babysitting), a parent can open an account and contribute up to $6,000 per year.
Roth Conversions: In years of lower taxable income, convert all or a portion of the account from a traditional retirement asset to Roth. To do this, you would pay income taxes (but not penalties) on the portion that you convert. This tactic is only powerful if you are able to pay taxes outside of the converted amount.
Back Door Roth IRA: This strategy has been used by high earners to accumulate additional sources of tax-sheltered growth. An investor has taken advantage of every retirement option at work and has higher income than the limit for regular Roth contributions, so they make an after-tax contribution to a traditional IRA. Almost immediately, the investor then converts this account to Roth and continues to do this every year, reaping the long-term benefits of tax-free growth.
As an additional note, Congress has proposed either eliminating or limiting both the back door Roth and Roth conversions in recent months. Although nothing has passed, the opportunity might be gone in the future. If the IRS and Congress is trying to limit a benefit, it usually means that it is a good idea!
The Best Retirement is One Well Prepared For
Though a Roth IRA holds clear benefits for certain people, there is no one-size-fits-all when it comes to which IRA is best overall. And what may be appropriate this year, may not be next year.
It’s hard to anticipate what your tax rate will be in retirement, particularly if you’re decades away from leaving the workforce. As such, it can be a good idea to hedge your tax bets and contribute to both. If you do, it will give you options, and limit your tax risks.
Seeking guidance from a professional can be a great way to help you feel confident in your decision making, and know when changes may need to be made. If the time feels right for you to start working with a financial advisor, please do get in touch. I’d love to chat and see if Abeona Wealth could be a good fit for your needs.