- Traditional IRA contributions may be income tax deductible and have
tax-deferred growth potential
- Roth IRA contributions are made after-tax and potentially grow tax free
- Your current and future income tax rates are a consideration when
deciding between traditional and Roth IRA contributions
When Shakespeare wrote this line in the legendary play Hamlet, perhaps he really meant to write: should I contribute to a traditional or a Roth IRA? Or maybe he meant to ask: what the heck is the difference between traditional and Roth IRA contributions? Let us answer these eternal questions.
An IRA is a type of retirement savings account. Contributions to a traditional IRA are income tax-deductible and have tax-deferred growth potential, although restrictions on deductibility apply if actively participating in an employer retirement plan (such as a 401k) and if adjusted gross income (AGI) is above certain thresholds. Income tax deductions and tax deferred growth? Sounds great! Well, there is a catch. In the year the traditional IRA owner reaches age 72, withdrawals called required minimum distributions (RMD’s) must be taken annually from the account. Withdrawals are taxable at ordinary income rates. Additionally, withdrawals taken before reaching age 59.5 are taxable as ordinary income and subject to a 10% penalty, although there are a few exceptions such as first-time home buyer.
A Roth IRA flips the rules of the traditional IRA. Contributions are made after-tax and potentially grow tax free, although there are restrictions on making contributions above certain AGI thresholds. Roth IRA’s offer some flexibility as contributions can be withdrawn tax free at any time. Sounds too good to be true, right? Well, yes. With some limited exceptions, withdrawals of Roth IRA earnings are taxable as ordinary income and subject to a 10% penalty if made before reaching age 59.5 and if made before five years has passed since the first contribution was completed. Roth IRA’s are not subject to RMD rules.
There are a few other important considerations when it comes to contributing to traditional and Roth IRA’s. You or your spouse must have earned income to be eligible to contribute and the maximum contribution is the lesser of earned income or $6k (an additional $1k catchup contribution is available to people age 50 or older). You may contribute to both a traditional IRA and Roth IRA in the same tax year, but the maximum contribution is limited to a combined $6k.
This should all start to become clear now. Just one minor detail: how in the world do I decide between traditional or Roth IRA contributions? Great question! The answer may depend in part on your current income tax rate versus your expected income tax rate in later working years and in retirement. If you are young and expect your earnings to increase in the future, the ideal course could be to sock money away in a Roth IRA. If you are in peak earning years and expect your income tax rate to drop once retired, it may be preferable to make traditional IRA contributions, while funds will not be taxed until withdrawn in retirement. If you are unsure about your future tax rate, unsure about future income tax law or just want your retirement savings to be tax diversified, it may make sense to make a combination of traditional and Roth IRA contributions. Sometimes a decision on traditional versus Roth is an art form rather than a science, which no doubt Shakespeare could appreciate!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
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