Roth vs. Traditional
Did you contribute to the maximum IRA limits for 2018? Did you add money to your Traditional or Roth IRA and which is better?
What if I told you it doesn't matter which Individual Retirement Arrangement (IRA) you contribute too? The subject, Time Value of Money, were common questions always asked to get students to pick one or the other in hopes of stumbling these college students. These are trick questions, but marketers use them to entice investors to fund their accounts because investment firms make money!
Shocking, I know!
When trying to cut through the legal jargon, it can be quite confusing to decipher which type of IRA is best.
The question boils down to where will tax be in the future compared to today, but I must mention Wealth Creation is the key to financial success, not taxes.
Looking at the illustration below comparing Traditional IRA to a Roth IRA, assuming all things are equal, you can easily see there is no difference. When investing $100 in both accounts, the traditional IRA is not taxes initially because you have opted to have it taxed later when you retire.
With the Roth IRA, you have chosen to have your money taxed today. For all tense and purposes, we are assuming the tax rate at 30%. The traditional IRA has the advantage immediately to invest the full $100 but with tax consequences later while the Roth IRA has only $70 to spend today because you have chosen to have taxes pulled out.
With both accounts having the same growth rate, let us fast forward several years to where you are eligible for retirement. Since you have already paid taxes on the Roth IRA, you have $140 to withdrawal.
Traditional IRA has a value of $200, but now you owe taxes. Assuming an equal tax rate of 30%, you see a deduction of $60 therefore, leaving you with $140--the same amount.
Now if taxes increase in the future, then taking out 30% taxes today saves you money compared to paying 40% in taxes 10 to 15 years in the future.
When saving money for retirement, the Traditional or Roth IRA are both tax-friendly options to help you save money. In the previous paragraphs, you read about the tax impacts on each and how there is very little difference in the end. It then becomes which arrangement best suits your needs.
Types of IRAs & Contribution Limits
The first type you will learn about is the Traditional IRA. If you have "taxable compensation" and are not 70-1/2 or older, you can contribute up to $5,500 (2018 contributions) and $6,000 (2019 contributions) annually if you are under the age of 50. If you are 50 and older, you are allowed to contribute an extra $1,000 annum making your annual contributions $6,500/$7,000, respectfully. If you're currently retired but under the age restrictions and receiving income from a pension, this does not qualify you to save money in an IRA if that is your only source of income.
Note: Should you contribute more than the annual limitations, you will be subject to a 6% penalty.
Are your contributions deductible?
According to the IRS, if you have a retirement plan at work, "Your deduction may be limited if a retirement plan covers you (or your spouse, if you are married) at work and your income exceeds certain levels." However, if you do not have a retirement plan at your employer, then "Your deduction is allowed in full if you aren't covered by a retirement plant at work." Check your appropriate Filing Status HERE.
The Traditional IRA, as seen in the illustration, allows you to pay taxes on your retirement withdrawals later down the road.
If you rather pay taxes sooner because you believe taxes will increase, then the Roth IRA is the second type you should consider. With the same annual contribution limits as the Traditional, the Roth IRA allows you to pay those taxes today so later down the road when you retire, assuming you met essential qualifications, you can pull your withdrawals tax-free.
The kicker here is you cannot leave your money in an IRA forever. The IRS will not allow that to happen. Generally, you must start taking withdrawals from your IRA when you reach 70-1/2 if you own a Traditional IRA.
Read here for calculating the Required Minimum Distribution (RMD). If you are already at 70-1/2 and "don't need the money to live on, wait until December to take your RMD and ask the sponsor to withhold a big chunk for the IRS, enough to cover your estimated tax" [excerpt from Kiplinger's Retirement Report, October 2018].
While you are required to start your withdrawals from a Traditional IRA by 70-1/2, you can begin taking withdrawals from either IRA type without penalty after age 59-1/2. Any distributions taken before this age are subject to a 10% penalty at your regular income tax rate. Fortunately, there are some loopholes. The penalty will not be applied if distributions are taken for the following reasons:
Death of Primary Account Owner
First-Time Home Purchase (up to $10,000)
Expenses towards education (see IRS.gov for rules)
Medical Premiums (unemployed individuals) & Medical Expenses (more than defined AGI limits)
What if I believe taxes will be lower in the future when I withdraw? This is where we pull out our crystal ball, but unfortunately, we do not have one yet. If you believe taxes will be lower in the future, then you are correct. The better option to invest is the Traditional IRA since you pay taxes later. The toughest part about this scenario is that nobody knows where taxes will be in the future.
In 2017, the Teachers Insurance and Annuity Association of America, TIAA.org, conducted a survey which reflects that one-third of Americans hold an IRA and "only 5 percent of Americans take full advantage of this savings tool by contributing more than $5,000 a year to IRAs."
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Best Way to Supplement Your Retirement Plan Savings
Which tax bracket are you in currently? If you are in a low tax bracket, you should consider contributing to a Roth IRA. Odds are, if you are already contributing to an IRA through your employer, it is most likely a Roth IRA. I encourage you to check.
For higher tax brackets, consider a Traditional IRA because "those in low tax brackets are not getting much current tax savings via the deductible IRA and are likely to be in a higher bracket due to increased income and wealthy by the time they retire." With that, I recommend you consult with a tax or financial advisor.
If you already have funds in a Roth IRA, then consider leaving it in a Roth because the withdrawals later down the road are tax-free once you reach the appropriate legal age. If you have funds in a Traditional IRA but looking to convert those to a Roth IRA, then I must warn you!
Source: 2017 TIAA IRA Survey
You may be responsible for paying taxes this year when converting from Traditional to a Roth, as well as, a 10% penalty if you need funds to pay those taxes! You will have to determine which account is best for you and you must inquire with your local tax laws to ensure you aren't impacted but local laws as well.
Which is Best to Contribute
Once again, it is going to depend on your financial circumstance, your financial goals, and your future tax situation. I would argue it is best to pick one and stick with it after conducting some homework and research because if you can save any money from tax consequences towards retirement, it is still beneficial because one day you may need that money to fund your lifestyle or financial needs.
Best IRA Accounts to Use
Eric Rosenberg lists in thebalance.com several of the best IRA accounts to use in 2019 based on a variety of factors. These factors include access to funds with no trading fees, minimal to no account fees, availability, and access to funds, and research capabilities.
While several of these firms are well-reputable, I must highlight that one of the firms mentioned in this list was charged by the SEC, Wealthfront, for making "false statements about a tax-loss harvesting strategy."
I use one of the firms listed in the article, Betterment, but I also recommend USAA IRA Investments for diversification purposes. I like this financial institution because of its simplicity. With their three-step process, the bank walks you through step-by-step asking essential questions to help determine if a Roth or Traditional is best for your financial needs.
Next, a variety of investments will be presented based on your risk tolerance and financial scenario. Then you establish a way to fund your IRA. You have the option to make an initial investment or make automatic investments as little as $50 per month.
One of the first steps in building your retirement fund is by making regular investments and contributions to it. Social Security may not be around. Pensions are quickly fading. It is becoming more clear that only we can take the appropriate steps and actions to secure our retirement.
If you have any questions, feel free to contact me at firstname.lastname@example.org and be sure to follow my blog on Instagram @DollarOtter_blog. Here are a few recommended books to read that has helped educate me: The Truth About Retirement Plans and IRAs by Ric Edelman, Complete Guide to Money by Dave Ramsey, and IRAs, 401(k)s & Other Retirement Plans by Twila Slesnick.