Deciding Factors for Different Types of IRAs

The different kinds of IRAs are complex but not impossible to understand. The biggest difference is all about the taxes.

There are pros and cons for both traditional IRAs and Roth IRAs. It is possible that you might end up using both of them in your retirement planning. The important factors that you need to consider are well-outlined in a recent article from Motley Fool, “Which IRA Is Best for Me — Traditional or Roth?”

The most significant difference between traditional IRAs and Roth IRAs is how they are taxed. Traditional IRAs typically tax up-front with a deduction on the amount contributed. This means that there is an immediate tax savings in the year in which you make the traditional IRA contribution. Roth IRAs don’t have an up-front tax deduction, so you must use after-tax money to make your contributions.

However, in retirement, the tax benefits are flipped: traditional IRAs aren’t as great in retirement, because you have to add any withdrawals to your taxable income when you take them. By contrast, Roth IRA withdrawals are usually tax-free, creating no impact on your taxes in retirement.

Forced withdrawals in retirement. Another difference is how they address required minimum distributions (RMDs). Traditional IRAs typically require withdrawals as soon as you reach age 70½, with the amount based on your life expectancy. If you don’t take these withdrawals, you’ll owe the IRS a penalty of 50% of the amount you should’ve withdrawn! Roth IRAs don’t have this requirement, so you can keep money in the Roth as long as you’d like. That can be useful if you’re using your retirement account assets for estate planning. Stretch IRA strategies can extend the tax-free treatment of Roth IRAs for generations after your death.

Income prevents you from having the IRA you want. Income limits prevent taxpayers from making contributions to a Roth IRA, and a phase-out exists in which you can contribute only a portion of the maximum that most savers can contribute. In 2017, it’s $5,500 for those under age 50 or $6,500 for those 50 or older. Here are the income limits.

Filing Status	Contributions are reduced if income is above this amount…	…and contributions are not allowed if income exceeds this amount…
Single, head of household, or married filing separately if you didn’t live with your spouse during the year	$118,000	$133,000
Married filing jointly or qualifying widow or widower	$186,000	$196,000
Married filing separately if you lived with your spouse at any point during the year	$0	$10,000

 

Source: IRS.

There’s no income limit on contributions for traditional IRAs, so you can deposit the full contribution amount. But you may not be able to deduct your contributions from your taxable income, if you or your spouse is covered by an employer-sponsored retirement plan at work. Here are the income limits:

Filing Status	Limits If You’re Covered	Limits if Your Spouse is Covered but You’re Not Covered
Single or Head of Household	$62,000 to $72,000	N/A
Married Filing Jointly	$99,000 to $119,000	$186,000 to $196,000
Married Filing Separately	$0 to $10,000	$0 to $10,000

 

Source: IRS.

To pay the least amount of tax possible, try to see if your current tax rate is higher or lower than what your tax rate will be in retirement. It’s not easy to guess, especially if retirement is years away.

If you are in a high tax bracket now, you will want a deduction now. That means you should choose a traditional IRA. However, if you are in a low tax bracket, take a look at what a Roth can do, because the deductions that a traditional IRA yields won’t do you much good right now. In either case, understanding how both of these retirement accounts work, will help you make the best decision.

Reference: Motley Fool (May 29, 2017) “Which IRA Is Best for Me — Traditional or Roth?”