IRAs: Traditional Vs. Roth

 

Traditional IRA vs. Roth IRA

Planning for retirement is a must do for people regardless of your age. The sooner you start, the better. With the power of compounding interest, your retirement account will grow exponentially. Now while many people have access to an employer sponsored plan; in most cases a 401(k), an Individual Retirement Account (IRA) allows you to save money for retirement without an employer. There are several types of IRAs but the two most popular plans are Traditional IRAs and the Roth IRA. Both have their own tax benefits. Let's start by going over the specific differences of each one:

TRADITIONAL IRA:

Started in 1974

Tax caveat: The annual contributions are deductible (with some limitations) - whilst the distributions at retirement are subject to ordinary income tax.

Early withdrawals (before age 59.5): Taxed as ordinary income and may be subject to a 10% penalty with certain exceptions.

Income Limit: If you or your spouse participate in a company retirement plan, deductibility is subject to income limitations.

 

ROTH IRA:

Started in 1998, named after Senator William Roth.

Tax caveat: The annual contributions cannot be deducted - whilst the distributions are retirement are tax free.

Early withdrawals (before age 59.5): Principal contributions can be taken out tax & penalty free, earnings may be taken out subject to a penalty and tax, with no penalty for certain exceptions.

Income Limit: based on your income, direct contributions may not be allowed, requiring use of the back door method to contribute.

Now that the differences of each are reported above, let’s get down to comparisons of which is best. There are many people that believe traditional IRAs are the best. I do not believe this.

Most common argument on behalf of Traditional IRAs:

"I am deducting my income right now at a higher tax bracket, taking the money and paying taxes when I am older at a lower tax bracket."

Fact is this cannot be proven outright as it is not known how much you will need at retirement. Generally, you may need less income as your mortgage is more likely to be paid off, and your lifestyle may not be as active. I am going to take a different approach to this. Chances are, if you deduct your traditional IRA contributions now, you may pay more in tax at retirement.

Currently, the income limit to deduct traditional IRAs before reaching phaseout is $73,000 ($116,000 if married filing jointly). At the current tax brackets, this falls under the 22% federal tax bracket. This 22% bracket is due to the Tax Cuts and Jobs Act (TCJA) signed into law December 2017, taking affect in 2018. These reduced brackets are set to expire after 2025. Starting 2026, we will be back to the regular tax rates. If you were to take the money out at the pre-TCJA rates, the same amount will be taxed at 25%. You will end up paying 3% more than what your savings are now. Yes this is less than three years away, and your contributions will entail a 25% savings then, so this may not be a good enough for everyone.

In the next forty years, we will go through up to ten presidential transitions, and double that number for congressional transitions. Due to the federal government’s growing national debt and annual deficit, speculation suggests tax rates will rise over the next many decades to reduce our deficit and pay down the national debt. It cannot be fully determined what will happen long term. It cannot even be determined if the TCJA rates will be extended before taking place again in 2026.

Additional Roth benefits:

The tax benefits of the Roth IRA go beyond simply not paying tax on retirement distributions; the tax free distributions create additional indirect benefits.

1. Your social security is less likely to be taxed.

- Tax on social security is based on taxable income on sources other than social security. after making over $25,000 - 50% of your social security income is taxable. After $34,000 - 85% is taxable. Traditional IRAs will increase your income, likely to create income tax for social security, whereas Roth distributions will not, allowing you to keep more of your money at retirement.

2. Health expenses are more likely to be deductible.

- as you should know, qualified health expenses are deducted as Itemized Deductions on schedule A. However currently, only total health expenses in excess of 7.5% of your Adjusted Gross Income (AGI) can be deducted on schedule A, meaning if you have an AGI of $100,000 – your total health expenses in excess of $7,500 are deductible. Furthermore, your total itemized deductions need to exceed your standard deductions to be deductible.

- With traditional IRAs increasing your AGI, this will also increase the income threshold for health expense deductibility. Roth IRAs will not.

3. Charitable contributions may be more beneficial.

- Charitable contributions are also deducted as Itemized Deductions on schedule A.

- you can directly donate to a charitable organization from the Traditional IRA (Qualified Charitable Distribution), this amount will not be taxed, and it will also not be deductible on Schedule A.

- However, if you take a distribution from your Roth IRA and donate to charity; not only will it not be taxed, it can also still be included on Schedule A, a type of double benefit.

These few additional benefits certainly make a case for Roth IRAs; There is one additional benefit.

Required Minimum Distributions (RMD): Traditional IRAs require a certain percentage of the account be withdrawn each year at retirement. Because you are not paying tax at contribution, the government forces you to take some distribution at retirement to produce tax revenue. While this caveat exists for traditional IRAs, this is not the case for Roth. Roth = No RMD. You may reduce your RMD with a Qualified Charitable Distribution mentioned above, but even then; Roth IRAs seem to be a superior choice.

Final thought:

If you currently have a traditional IRA, and/or have been contributing to one, but would like to switch to the Roth, couple things to do.

1.      STOP contributing to the Traditional. Open the Roth IRA and contribute to the account going forward.

2.      Consult with your CPA regarding your current Traditional IRA account and its balance:

a.      A higher balance rolled over into a Roth will have a higher income tax in the year of rollover.

b.      It may be worth it to simply keep the account, and withdraw a nominal amount each year whilst using other sources at retirement.

Hopefully this article is helpful to all readers wondering if they are making the correct choice. At the end of the day, you should consult with your personal CPA. Your personal circumstances will at the end determine the best course of action.