Deciding Between a Roth vs. Traditional IRA

If you’re looking to boost your retirement savings, it’s a wise idea to open an individual retirement account, commonly known as an IRA. Though similar to 401(k) plans found in the workplace, an IRA can give workers more investment options and greater control over how their assets are managed.

In 2019, you will be able to contribute up to $6,000 to an IRA or, if you’re age 50 or older, up to $7,000. You can also choose between two IRA options: a traditional account or a Roth account.

Which one is better? “The answer is really going to depend on your individual circumstances,” says Ryan Reed, a wealth strategist with financial firm PNC Wealth Management. A traditional IRA offers an immediate tax deduction for contribution, while a Roth IRA can provide tax-free income in retirement.

Here’s what Reed and other experts say you need to know in order to make an informed decision.

[See: 10 Tips to Boost Your IRA Balance.]

Consider Tax Benefits

If you expect that your tax rate will decrease when you retire, opt for a traditional IRA. Traditional IRAs mean tax savings now.

Contributions made to traditional accounts are tax deductible. In exchange for receiving a deduction now, the government taxes withdrawals made in retirement at a person’s regular tax rate. If a withdrawal is made before age 59 ½, the IRS also adds a 10 percent penalty. Regardless of whether a retiree wants the money, the government insists people begin taking a required minimum distribution, known as an RMD, at age 70 ½.

“Someone is going to pay taxes on it sooner or later,” says Yvonne Marsh, a certified financial planner and CPA with financial firm Marsh Wealth Management in Knoxville, Tennessee.

High-income earners may find it best to take a deduction now and pay taxes in retirement when they could be in a lower tax bracket. If a retiree passes away prior to using all the money in a traditional IRA, heirs will pay taxes on the proceeds instead.

If you anticipate higher taxes in retirement, a Roth IRA can be advantageous. In 1997, a new version of the IRA was created. “Senator William Roth of Delaware came up with this idea to help people save more,” explains Eric Aanes, CEO and founder of financial firm Titus Wealth Management in Larkspur, California.

Rather than receive a tax deduction for contributions, Senator Roth proposed allowing people to fund an IRA with after-tax money. Since the contributions had already been taxed, withdrawals in retirement would be tax-free. What’s more, gains made on the investments could also be withdrawn tax-free. His idea was included in the Taxpayer Relief Act of 1997, and this new savings option became known as the Roth IRA.

Unlike traditional IRAs, there is no RMD for a Roth IRA. While there is still an early withdrawal fee of 10 percent for any gains pulled out of an account prior to age 59 ½, workers can take out their principal payments at any time without penalty.

Take your current tax bracket into account. Your tax bracket is one of the most important considerations when deciding between a traditional and Roth IRA. “You might be in a higher tax bracket (now) than you’ll be in retirement,” Reed says. In that case, it might be best to contribute to a traditional IRA and receive a deduction while your tax rates are higher.

However, don’t assume your tax bracket will be lower after you stop working. “What I find with clients is that’s not always the case,” Reed says. Pensions, Social Security and investments can quickly add up to replace much of a person’s pre-retirement income.

Retirees also often forgot or underestimate the amount of the required minimum distribution that must be taken out of traditional 401(k)s and IRAs after they reach age 70 ½. That amount is dictated by a formula that could push a person into a higher tax bracket or make a portion of his or her Social Security benefits taxable.

[See: 11 Ways to Avoid the IRA Early Withdrawal Penalty.]

Understand when you’ll need the money. Both traditional and Roth IRAs can be subject to early withdrawal penalties, but Roth accounts offer more flexibility. All money withdrawn from a traditional IRA before age 59 ½ is subject to a 10 percent penalty in addition to regular income taxes, though the penalty can be waived in certain situations, such as if you’re unemployed and use the money for health insurance.

However, only the gains made on contributions to a Roth account are subject to the penalty. You can take out the principal amount at any time and for any reason. Since that money has already been taxed, it isn’t subject to additional income tax either.

A Roth IRA is also more flexible in retirement. Remember, you’ll have to take a distribution from a traditional IRA every year after you hit age 70 ½. That extra income will be taxable and could push you into a higher bracket.

How to Open an IRA and Pick the Right Account for You

When it comes to selecting the right brokerage firm to manage your IRA, you’ll want to look for a service that will minimize your expenses and help you find investment funds that match your risk tolerance and retirement goals.

Here are the key steps required to open an account and start reaping the benefits of tax breaks and deductions.

1. The IRS may make the choice for you. High-income families may not have a choice between a traditional or Roth IRA. Only those taxpayers who meet certain income criteria are eligible to contribute to a Roth account.

In 2019, those filing jointly who earn below $193,000 as a married couple can contribute up to the full Roth IRA limit. Then, the ability to contribute phases out; those earning more than $203,000 are not allowed to put money into a Roth IRA. For single taxpayers, the ability to contribute begins to phase out at incomes at or above $122,000.

Meanwhile, anyone can contribute to a traditional IRA, but for those who have access to a 401(k) or similar workplace retirement plan, contributions are only deductible for those meeting income requirements. Single taxpayers with modified adjusted gross incomes of up to $64,000 can deduct their full contribution, up to the annual limits, while the deduction phases out for those earning more. The deduction for married couples filing jointly begins to phase out at income levels exceeding $103,000.

“If you can’t get the deduction, you should be looking at another investment,” Marsh says.

2. Select an IRA brokerage firm. When it comes to opening and funding an account, you’ll need to work with a brokerage firm. You have two options: a full-service brokerage or a robo advisor.

Full-service investment firms will provide an advisor to walk you through the process of opening an IRA. These companies can be a good choice for someone who wants a personal contact with a company to answer questions and provide customized service. A less expensive option is to use a newer automated service known as a robo advisor. Companies like Betterment and Wealthfront make it easy to open an IRA online. The service then manages assets with little oversight required by you, making them ideal for hands-off investors.

Remember, tax diversification is important. Just as workers should spread their investments among funds with various levels of risk, it makes sense to diversify money between traditional and Roth accounts. “What might be a mistake is to think you only need to (contribute) to one or the other,” Reed says.

Instead, workers can split their money between the two types of IRAs to hedge against changing tax rates. Then, as people get closer to retirement, they can gauge whether it’s wise to convert money from a traditional IRA to a Roth IRA.

[Read: Investors Face New Rules to Convert an IRA.]

Money converted is subject to regular income tax, and workers may find it beneficial to convert just enough each year to avoid pushing them into a higher tax bracket. “Right when people retire, and they get at a lower tax bracket, converting may be a good way to get the ball rolling,” Aanes says.

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