Many individuals ask which is better, the Traditional IRA or Roth IRA. The answer to this debate is: it depends. There are 5 important considerations when choosing between the Traditional IRA and Roth IRA.
1. Can You Deduct Your IRA? Can You Contribute to a Roth IRA?
Not all Traditional IRAs are Deductible. There are limitations that the government has put in place, starting with those who are offered retirement plans through work. If you are offered retirement benefits through work, you may not be able to deduct your Traditional IRA contributions.
The Roth IRA also has limitations. Those who earn too high of income cannot contribute to a Roth IRA. So, considering your employer retirement plans and earned income also will help determine whether the Traditional or Roth IRA is the optimal choice. See the IRS.gov Rules for Deductible IRAs and Roth IRA income limits
2. Expected Future Income Tax Rate
The next and probably most obvious consideration is whether you believe your income will go up or down in retirement. Many people have supplemental income when they retire from rental properties, self-employment income, not to mention RMDs (Required Minimum Distributions) from Traditional IRAs, social security benefits, and dividends and interest income.
One major advantage to the Roth IRA is one is not required to take RMD at age 70 ½. Many people are shocked to find with Traditional IRAs, their RMDs plus all other income can actually drive them up to a higher tax bracket during retirement. Therefore, considering income during working years, estimated RMDs, and dividend and interest income will help determine if the Traditional IRA or Roth IRA is right for you.
3. The Impact of RMDs and Retirement Income
As mentioned above, Traditional IRAs mandate the account owner start withdrawing funds at no later than April of the year after turning 70 ½. Social Security Benefits become 50% taxable once your income exceeds $32,000 and 85% taxable once income exceeds $44,000 (married couples – 2019). Sometimes RMDs force individuals and couples to file taxes when otherwise they would have not owed tax. Determining retirement income will help decide whether the Traditional or Roth IRA is the optimal choice.
4. Tax Diversification – Lower Your Income During Retirement
Another overlooked component is tax diversification. If all savings are within Traditional IRAs, well, then RMDs can drive up your income tax during retirement. On the other side, if all savings are within Roth IRAs, individuals may have paid more tax during their working years. Savings within both Traditional and Roth IRAs offer flexibility and control when income is needed. For example, if a taxpayer wants to withdraw $100,000 one year to put down on a vacation property, and the $100,000 is from Traditional IRA savings, they will likely find themselves jumping up in to a higher tax bracket, owing more tax than anticipated. However, if that taxpayer withdrew $50,000 from Traditional IRA and $50,000 IRA from Roth savings, they could find themselves strategically determining how much they pay in tax.
5. Estate Planning Strategy for Beneficiaries
When non-spouse beneficiaries inherit Traditional IRAs they must begin withdrawing RMDs the following year and paying income tax on the withdrawals. There is no avoid RMDs on inherited Roth IRAs like regular Roth IRAs, but the beneficiary does avoid paying tax (on qualified distributions). So, considering your beneficiary is another component when choosing between Traditional or Roth IRAs.
There are more considerations than just those listed when choosing between Traditional and Roth IRA savings. Depending on retirement age and when the taxpayer claims social security, there can be a window of opportunity to convert Traditional IRAs into Roth IRAs at a lower tax rate. This can result in more long term wealth retained throughout retirement.
Article by Matthew Ward