IRAs are a great tool for helping ensure a financially secure retirement. Even though many people participate in a retirement plan at work, like a 401(k) or 403(b) plan, IRAs still remain popular — especially among people who don’t have access to an employer-sponsored plan.
Differences Between Types of IRAs
Before opening an IRA, though, you’ve got an important decision to make: Should you open a traditional or a Roth IRA? There are important differences between them that you should understand if you want to make the best decision for your situation.
Established by Congress in 1975, traditional IRAs were the first tax-advantaged plan sponsored by the government to help Americans save for a financially secure retirement. You can deduct IRA contributions during the tax year that you make them, which lowers your taxable income and possibly your taxes. You’ll pay taxes at ordinary income tax rates when you start taking IRA distributions in retirement.
In 1998, Congress created a new type of IRA — the Roth IRA — that offers a different tax benefit. You don’t receive a current tax deduction; instead, you’ll withdraw your saving tax-free in retirement. This can help stretch your retirement nest egg further and increase the chances that you don’t run out of money before you die.
Factors to Consider
There are several different factors you should consider as you decide which type of IRA is best for you. The first is whether you qualify to open and contribute to a Roth IRA.
If your modified adjusted gross income (MAGI) is greater than $203,000 (if you’re married and file jointly) or $137,000 (if you’re single), you’re ineligible for a Roth IRA and must choose a traditional IRA. If your MAGI is between $193,000 and $203,000 (if you’re married and file jointly) or between $122,000 and $137,000 (if you’re single), you can make a reduced Roth IRA contribution.
The next thing you should determine is whether you can deduct contributions to a traditional IRA. If neither you nor your spouse has access to a retirement plan where you work, you can fully deduct your traditional IRA contributions. However, if either you or your spouse has access to a retirement plan where you work, your deduction might be limited, depending on your MAGI.
Tax Deduction or Tax-Free Withdrawals?
Assuming you’re eligible for a Roth IRA, your decision mainly comes down to whether you want to receive a tax break now … or later? In other words, do you place more value on a current tax deduction or tax-free account withdrawals in retirement?
Tax brackets should play a role here. If you’re currently in a lower tax bracket than you expect to be in when you retire, a Roth IRA might be better since withdrawals in retirement will be tax-free. But if you’re currently in a higher tax bracket than you expect to be in when you retire, a traditional IRA might be better since you could pay less in taxes when you start taking withdrawals in retirement.
Withdrawal rules are another consideration. If you withdraw funds from a traditional IRA before your turn 59½ years old, you’ll generally have to pay a 10% early withdrawal penalty. However, you can withdraw contributions (but not earnings) from a Roth IRA penalty-free at any age. Also, you must begin taking required minimum distributions (or RMDs) from traditional IRAs when you turn 72 years old, but there are no RMDs with Roth IRAs.
Weigh Your Circumstances
There’s no one-size-fits-all answer to the question of whether you should choose a traditional or Roth IRA. It will depend on circumstances unique to your situation.
Give us a call if you would like to discuss traditional vs. Roth IRA in more detail as it pertains to your circumstances.