What You Need to Know About Traditional and Roth IRAs
You have a few options when saving for retirement. One common way is to participate in an employer’s retirement savings plan. This might be a 401(k), 403(b), SEP IRA, or SIMPLE IRA, among other examples. If you get a company match on your contributions (free money!), these plans can be particularly attractive.
And then there’s the classic Individual Retirement Arrangement – or IRA, for short.
IRAs let you save and invest money for…wait for it…retirement. These accounts are special because your money can grow tax-free. With regular investment accounts, you’ll have to pay taxes on any income or capital gains you make that year.
Let’s look at the two types of IRAs and some of the issues you should think about when trying to choose between them.
Two Types of IRAs: Traditional and Roth
The two types of IRAs out there – Traditional and Roth – look and act very similarly. But there are important differences between these accounts.
For example, contributions to Traditional IRAs are normally tax-deductible. Meaning, if you contribute $6,000 to a Traditional IRA and are in the 22.0% tax bracket, you’ll get a $1,320 tax benefit from the contribution. You’ll see this referred to as a “pre-tax contribution.”
On the other hand, contributions to a Roth IRA are NOT tax-deductible. So if you contribute the same $6,000 to a Roth IRA you won’t get any tax benefits. This is referred to as an “after-tax contribution.”
The issue of pre-tax or after-tax contributions will become clear later in this post. But first, there are some basic rules about IRAs that you need to understand about IRAs.
IRA Contributions: The Basic Rules
There is a limit to how much you can contribute to an IRA each year. Traditional and Roth IRAs have the same contribution limit, as you can see here:
So if you’re 54 years old and make $75,000 a year, you can contribute $7,000 to either a Traditional or Roth IRA in 2019. This would be on top of anything you contributed to your employer retirement plan.
The same person – aged 45 instead of 54 – could only contribute up to $6,000 to their IRAs.
Important Rule: You can only contribute up to however much you make in Earned Income during the year. Earned Income is generally the wages you’d earn at a job. So if you make $4,500 this year, the most you’d be able to put into an IRA is $4,500. [Another way to put this is that your maximum contribution is the lower of your Earned Income or the Contribution Limit for your age.]
This is straight forward enough. But we all know the IRS doesn’t like to make life simple on us country folk. And it’s no different with IRA contributions.
There are other limits to contributions that tax pros like to call “phase-outs.”
What’s odd is that these phase-outs act differently:
- Phase-outs for Traditional IRAs determine whether your contribution is tax-deductible or not. You can always contribute to a Traditional IRA, but it won’t always be tax-deductible.
- Phase-outs for Roth IRAs determine whether you can contribute to a Roth IRA or not. You might not be able to contribute to a Roth IRA, but when you do it’s never tax-deductible.
This almost sounds like a Dos Equis beer commercial. Sorry…I don’t make up the rules! But I’ll clear it up for you below.
Let’s tackle Traditional IRAs first.
You can ALWAYS contribute to a Traditional IRA regardless of how much you make as long as you or your spouse have Earned Income. It doesn’t matter if you make $4,500 or $4,500,000 – you can open a Traditional IRA account and put money in up to your Contribution Limit.
The phase-out rules for Traditional IRAs determine whether your contribution is tax deductible or not. I’ll lay the rules out in a table and then explain how these phase-outs work.
The best way to explain these phase-out is to use examples.
Example 1: If you and your spouse both work and participate in your employer retirement plans, then:
- If you make less than $103,000 in combined Modified Adjusted Gross Income (MAGI), your Traditional IRA contributions are 100% tax-deductible. Your income is below the phase-out threshold of $103,000 – $123,000.
- If you make more than $123,000 in combined MAGI, then you can contribute to your Traditional IRA but those contributions will NOT be tax-deductible.
- If you make somewhere between $103,000 and $123,000 in combined MAGI, then only part of your contribution to a Traditional IRA would be tax-deductible.
Example 2: Your spouse works and participates in an employer retirement plan but you don’t. If you contribute to a Traditional IRA, then:
- Your contribution will be 100% tax-deductible as long as your combined income is less than $193,000
- Your contribution will NOT be tax-deductible if your combined income is more than $203,000
- Your contribution will be partially deductible if your combined income is between $193,000 and $203,000.
- Any contribution to a Traditional IRA by your spouse (who’s covered by a retirement plan) will follow the rules in Example 1.
Lastly, if neither you nor your spouse works at a job that offers retirement benefits, then your contribution to a Traditional IRA will be tax-deductible no matter how much your combined income is.
Phase-outs for Roth IRAs
IRS phase-outs for Roth IRAs determine whether you can contribute to a Roth IRA or not. If you can, those contributions will always be made with after-tax money. Put another way, you NEVER get a tax deduction for contributing to a Roth IRA.
Example: Jack and Jill Smith are both 40 years old and want to contribute their maximum to a Roth IRA ($6,000 each) in 2019. Here’s how much they can contribute based on their income:
- Combined income is <$193,000: They can both contribute the maximum to a Roth IRA for a combined total of $12,000. They won’t get any tax deduction from these contributions.
- Combined income is >$203,000: Neither spouse can make a contribution to a Roth IRA.
- Combined income is = $198,000: Since their income is right in the middle of the phase-out range, they can each contribute 50% of their maximum potential contribution. Meaning, $3,000 each instead of $6,000 each.
Despite these rules, there’s still a way you can get money into a Roth IRA if your income is above this phase-out range. It’s called a Backdoor Roth IRA strategy, which I’ll get into next week.
But for now, let’s look at why you’d want to choose a Traditional vs. a Roth IRA, and vice-versa.
Choosing Between a Traditional and Roth
Figuring out whether to contribute to a Traditional or Roth IRA comes down to many factors. But I want to highlight the most important factor this week.
The most important variable when choosing whether to contribute to a Traditional or Roth IRA is your tax rate today vs. your tax rate when you retire. Why? Uncle Sam is going to get his cut of your retirement income at some point. He’ll either get it up-front in the case of a Roth IRA, or on the back-end when you take money out of a Traditional IRA.
This example of a 45-year-old woman will help illustrate this for you.
> She wants to save $4,000 per year in total out-of-pocket cost
> She’ll save the same amount each year for the next 20 years
> She’ll be able to earn a return of 7.5% per year on her investments
> Her tax rate today is 22%
The first thing you have to remember is that she’s contributing $4,000 out-of-pocket. Because she gets a tax benefit from contributing to a Traditional IRA, she’d actually be putting more money into the Traditional IRA vs. a Roth IRA.
Now, she does the same $4,000 out-of-pocket contribution for the next 20 years. Here’s how each account would grow.
You see that the Traditional IRA balance is higher after 20 years. That’s because she’s putting more into that account vs. the Roth IRA. At first blush, you might think, “Hey, a Traditional IRA is better!” Not so fast, my friend.
Let’s look at what will happen if she takes the entire balance out at the end of the 20th year. Remember, she has to pay taxes on what she takes out of the Traditional IRA, but not the Roth IRA.
Let’s assume her tax rate in 20 years is the same 22% rate it is today.
Interesting isn’t it?! She’ll end up with the EXACT same amount after 20 years whether she contributes to a Traditional or Roth IRA!
Why did that happen? Her tax rate in retirement (22%) was the same as what it is today.
When your tax rate is expected to be the same in retirement as it is today, there won’t be any difference in the after-tax value of your IRA whether you contribute to a Traditional or Roth IRA.
But if your future tax rate is different than what it is today, the decision of whether to go with a Traditional or Roth IRA becomes clearer.
Watch what happens when your future tax rate is higher or lower than today.
If your future tax rate is expected to be lower than what it is today, then that would favor a Traditional IRA. Since contributions to a Traditional IRA are pre-tax, you won’t be “paying” a 22% tax rate today. Instead, you’ll pay 15% when you take the money out.
However, if your future tax rate is expected to be higher than what it is today, then you’re better off with a Roth IRA. Since your contribution to a Roth IRA is after-tax, you’re paying your tax today at 22%. But when you take the money out, you won’t owe a dime in taxes.
Here are the Rules of Thumb:
Tax Rate in Retirement < Tax Rate Today: Favor a Traditional IRA
Tax Rate in Retirement > Tax Rate Today: Favor a Roth IRA
Tax Rate in Retirement = Tax Rate Today: No difference; Traditional and Roth IRA will yield the same result
Knowing the basics of how IRAs work is important in planning for your retirement. There are a lot of factors that go into choosing whether to contribute to a Traditional or Roth IRA. By understanding the rules I’ve laid out above, you’ll be better equipped to choose the best option for your family.
I can’t emphasize how important it is to get this right. You don’t want to end up paying more taxes than you have to.
Next week I’m going to go over some other reasons why a Roth IRA might be the more attractive option vs. a Traditional IRA. There’s one important rule that applies to Traditional IRAs but not Roth IRAs, and this factor can tip the scale in favor of a Roth IRA, all else being equal.
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