Last month in our Investing Basics Series we looked at the overall parameters of how to have a better investment experience. This month, we’re going to take a closer into how you can make those investment accounts work for you.
This month’s blog focuses strictly on IRAs: the pros and cons of Traditional IRAs and Roth IRAs; which account is the best for you based on your current situation and economic trends; and to spice things up, we’re going to take a moment to talk about Roth IRA conversions.
What is an IRA?
An IRA, Traditional or otherwise, is a type of investment account designed to help you save for retirement. IRAs have certain rules and regulations that are designed to make it a little harder to access those funds in order to incentivize you to successfully save for retirement. Typically you can’t take money out of your IRA until you’re at least 59 ½ without incurring a 10% penalty fee and paying income tax on the money you withdrew (there are a few exceptions which we will get to later). IRAs are easy to open and usually require no minimum down-payment.
Check Your Eligibility
As of 2019, individuals are allowed to contribute up to $6,000 a year, or $7,000 a year if you are older than 50. However, there are restrictions on whether or not you can contribute and how much you can contribute based on your income tax bracket.
- Your income determines whether you are eligible to contribute to a Roth IRA
- Your income determines how much of your contribution to a Traditional IRA you’re allowed to deduct from that year’s taxes
If you’re thinking about opening an IRA, review these articles to make sure opening an IRA is in your best financial interest:
- Are you maxing out your 401K match or other employer-sponsored plans? (Link back to What Are the Different Types of Investment Accounts and Which One Should I Choose)
- Do you have 3 to 6 months’ worth of expenses saved up? (Link back to Budgeting Post)
Now answer the question:
- Are you paying down your high-interest debt?
If you are doing all of these things, you’re ready to open an IRA!
At this point it becomes a matter of determining which type of IRA is best for you. To do this we need to break down both types of IRAs.
Contributions Are Tax-Deductible
Contributions made to your Traditional IRA are tax-deductible in the year they are made on both the state and federal level. This means you don’t have to pay income taxes on the money you put into your IRA; i.e., you can deduct the contributions you made for the year.
As a result, contributions generally lower your taxable income for the contribution year. This in turn, lowers your Annual Gross Income (AGI) and helps you qualify for other tax incentives
you wouldn’t otherwise get.
2. Tax Free Growth
Traditional IRAs (and Roth IRAs) offer tax-free growth of assets. This means that you are not taxed on the dividends received or capital gains earned.
3. Penalty Free Early Withdrawal for Qualified Expenses
If you are under the age of 59 ½, you can withdraw up to $10,000 from your account without the normal 10% early withdrawal penalty to pay for qualified first-time homebuyer expenses and for qualified higher education expenses.
Hardships, such as disability and certain levels of unreimbursed medical expenses, may also be exempt from the penalty.
It is important to note that you do have to pay income taxes on these distributions.
Early Withdrawals Have a Penalty
If you are withdrawing money from your Traditional IRA before you are 59 ½ and it is not a qualified expense, you will have to pay a 10% early withdrawal fee, as well as income taxes on the money withdrawn.
2. Restrictions on When You Have to Take Money Out
With a Traditional IRA, you are required to take taxable withdrawals of a certain percentage of your funds, whether you need the money or not, by the age of 70 ½. These are called Required Minimum Distributions (RMDs).
3. Restrictions on When You Can Contribute
Not only do you have to start withdrawing money from your Traditional IRA by the time you are 70 ½, you also have to stop contributing to your Traditional IRA by the time you are 70 ½. This can deter leaving money to heirs, or if you live a very long life, lead to a shortage of cash in the long run.
4. Ending Up With Less After-Tax Money in the Long Run… Unless You’re Very Disciplined
The tax benefit of Traditional IRAs is that you don’t have to pay taxes on the money you contribute to the account in the year in which your contribution is made. You have effectively decreased your taxable income for that year. However, it is easy to consider the cash saved as “play money” or “extra cash” that can be spent.
To come out even in terms of after-tax savings as compared to Roth IRAs (I’ll discuss this in a few paragraphs), you have to be disciplined enough to re-invest the tax savings you get every year back into your retirement savings.
Withdrawals are Tax-Free
Perhaps the biggest pro for Roth IRAs is you do not have to pay any taxes on withdrawals during retirement. Unlike the Traditional IRA, with Roth IRAs you use after-tax dollars to contribute to your retirement savings. As such, you have already paid taxes on the money you contributed. This means the withdrawals and payouts you get on your Roth IRA upon retirement are generally tax-free.
2. Early Withdrawals Rules Are More Flexible
I’m not encouraging you to take early withdrawals from your retirement account, but if you must, it is much easier to do so with a Roth IRA than a Traditional IRA.
You can withdraw contributions (not earnings) at any time without having to pay income taxes or an early withdrawal penalty for certain expenses. To do so, your Roth IRA must have been open for 5 years.
3. Has Fewer Restrictions for Retirees
Unlike Traditional IRAs, Roth IRAs do not have RMDs (Required Minimum Distributions). You can let your savings stay in your Roth IRA and continue to grow tax-free as long as you live. When doing Estate Planning, this is a huge plus.
4. No Restrictions on How Long You Can Contribute
You can continue to contribute to your Roth IRA at any age and for as long as you want. You do not have to stop contributing at 70 ½ as with Traditional IRAs.
The ability to save your money and let it grow tax-free makes this a great option if you want to leave a financial legacy for loved ones. Beneficiaries of your Roth IRA do not owe income taxes on the withdrawals and they can stretch the distributions out over many years.
5. You End Up With More After-Tax Money
Because your tax break is delayed until retirement (tax-free withdrawals), you have less of an incentive to spend the money. If you are also funding a Roth IRA in conjunction with other qualified retirement savings accounts (Link back to “What Are the Different Types of Investment Accounts”), it provides tax diversification.
The Maximum Contribution is Low
As with Traditional IRAs, you can only contribute $6,000 per year and $7,000 per year if you are 50 or older. This isn’t a whole lot of money, especially if you start saving for retirement when in your 40s or later.
You’ll also need to invest in other qualified retirement accounts, such as a 401(k), which has a higher annual contribution limit of $19,000 in 2019. And if you are 50 and older, you can contribute an additional $6,000 to your 401(k).
2. Income Limits
You can only contribute to a Roth IRA if you make below a specific amount per year depending on your tax filing status (check the chart above to see if you can contribute).
The Biggest Difference Between a Traditional IRA and a Roth IRA
The main difference between a Traditional IRA and a Roth IRA is how and when you’re taxed.
The greatest tax advantage to Traditional IRAs is that contributions are tax-deductible on both the federal and state level for the year in which they are made. It isn’t until you withdrawal from your Traditional IRA that you are taxed at ordinary income tax rates.
Conversely, the biggest tax advantage of a Roth IRA is that while you have already paid taxes on the money you put into your IRA, you are not taxed on the funds when withdrawn and/or dispersed.
Contributions made to your Traditional IRA are tax-deductible in the year they are made on both the state and federal level. This means you don’t have to pay income taxes on the money you put into your IRA. When tax time comes around, you can deduct the contributions you made for the year.
So the main question becomes: Do you think your tax rate will be higher or lower in the future?
- If you expect to be in a higher tax bracket in retirement than you are now, go with a Roth IRA.
- If you expect to be in a lower tax bracket in retirement than you are now, then the Traditional IRA is the route you should take.
It’s hard to predict what the federal and state tax rates will be years from now. Given today’s historically low federal tax rates, many economists believe the federal income tax rates will rise in the future. If that’s the case, then Roth IRAs may be the better long term choice. One can look at past historical financial trends to help determine future ones, and just like with the stock markets, interest rate trends are cyclical.
If you would like to discuss Traditional IRAs and Roth IRAs in further detail, schedule a Get Acquainted Meeting with Hamilton Financial Planning today! We’d love to hear from you.