To Roth, or not to Roth

To Roth, or not to Roth

I get a lot of questions about IRAs so I thought a quick crash course in the basics would be helpful.  Tax laws, regulations and individual circumstances change frequently so always check with your advisor or tax consultant before making any decisions.

What is an IRA?

An IRA is an Individual Retirement Account.  It is a type of savings account that helps you save for retirement in a tax-advantaged way.  Your investments in Traditional IRAs will grow tax-deferred and your investments in a Roth IRA grow tax-exempt (tax-free).

What’s the difference between tax deferred and tax-exempt?

On a tax-deferred investment, you will not pay taxes until you withdraw the funds. On a tax-exempt investment, you will never have to pay taxes.*

*assuming you are taking qualified withdrawals.

What are qualified withdrawals?

For Roth IRAs you are always allowed to withdraw contributions you’ve made to the account tax and penalty free.  Qualified withdrawals for both types of accounts typically start at age 59.5 but there are all sorts of exceptions and other considerations to be aware of.  Fidelity does a nice job summarizing IRA withdrawals here.

What’s the difference between a Roth IRA and a Traditional IRA?

Although there are many, the main difference between Roth and Traditional IRAs is that Roth IRAs are always funded with after-tax dollars and Traditional IRAs are usually funded with deductible (pre-tax) contributions.

Read about all the differences here: Traditional IRA vs Roth.

Can I contribute to an IRA?

You can make Roth IRA contributions as long as you are alive, have earned income and the earned income does not exceed certain income limits.

You can make Traditional IRA contributions if you are under age 70.5 and have earned income.

How much can I contribute?

The maximum contribution to IRA accounts annually is currently $5,500 if you are under 50 years of age and $6,500 if you are over 50.  This is the total contribution to both accounts.   For example, you cannot contribute $5,500 to your Roth and $5,500 to your Traditional IRA but you could contribute $3,000 to your Roth and $2,500 to your Traditional.

For Roth IRAs, depending on your income, you will be eligible for full, partial or no contribution.

For Traditional IRAs, you can always contribute the maximum amount as long as the contribution does not exceed your earned income.  The amount of your contribution that will be deductible is based on your income and whether or not you participate in a workplace retirement plan.

What’s better: a Roth or a Traditional IRA?

General rule of thumb (very general): if you are eligible to make Roth contributions and you think you will be in a higher tax bracket when you begin to take distributions than you are now, it makes sense to pay the taxes now at a lower rate and not worry about paying them in the future (at a presumably higher rate).

If you think you’ll be in a lower tax bracket later when you begin to take distributions than you are now, use the Traditional IRA to deduct against your taxes now and pay the presumably lower rate in the future.

What if I don’t know what my tax rate will be in the future?

That’s a great question.  Nobody knows what their tax rate will be in the future!  That’s why there’s really no black or white answer here.

For that simple reason, I look at Roth IRAs as a way to diversify.  Not only is it smart to diversify the investments in your portfolio, but its also smart to diversify the tax treatment of your investments!

When it’s available, Roth contributions are usually a good idea.  One reason is because you don’t know what your taxes will look like in the future.  Another reason is that due to income restrictions, you might not always be eligible for Roth contributions.  Get that money in there while you can!

If my income level restricts me from Roth contributions or deductible IRA contributions, should I bother with non-deductible IRAs?

If you have maximized the benefits offered to you by workplace savings plans, non-deductible IRA contributions still provide you with a tax-advantaged way to save for retirement.  Don’t underestimate the power of tax-free compounding on your returns!

Further Reading…

Be Tax Aware

Tim Brennan

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