Roth IRA or Traditional IRA: Do you qualify for both?
So often we talk about either Roth IRA or Traditional IRA, but what is an IRA anyway?
IRA stands for Individual Retirement Account. And in essence, and IRA is a savings account that allows individuals to contribute pre-tax or post tax dollars for retirement.
But before we go too far deep, it is important to talk about upcoming contribution deadlines. The deadline to make your IRA contributions for the 2016 tax year is April 18th, 2017. Eligible taxpayers under age 50 can contribute up to $5,500, and up to $6,500 for taxpayers age 50 and older. Mark it on your calendar to insure you contribute to your Roth IRA or Traditional IRA (or both) before the deadline.
People don’t realize that they do not have to pick either their Roth IRA or Traditional IRA at the expense of the other. How you allocate your funds is one more piece of the puzzle to consider in your retirement planning. It’s worth taking a moment to remind yourself, “So… What’s The Difference Again?”
The Traditional IRA
Like all IRAs, the Traditional IRA comes with some tax benefits. This plan is set up through your employer to allow you to contribute your salary before taxation. That means your contribution reduces your tax liability for the year. On the flip side, distributions from this account are taxable income. This is the case in retirement or even in early withdrawal.
Put simply, with Traditional IRA’s you don’t get taxed when the money goes in, but do get taxed when the money comes out.
Withdrawals made before you reach age 59 ½ incur a 10% penalty (excluding a few specific circumstances). You will be required to begin withdrawing ‘minimum required distributions’ (MRDs) starting in the year you reach 70 ½.
Also keep in mind that it’s possible that contributions may drop your taxable income into a lower tax bracket, further reducing the tax impact within that year.
The Roth IRA:
Contribution limits within the year remain the same, however, your contribution to the investing account will be with after tax dollars. The funds within the account will grow tax free and will not be subject to taxation upon their withdrawal.
Put simply, with ROTH IRAs you do get taxed on the money that goes in, but do not get taxed when it comes out.
Earnings (but not contributions) are subject to early withdrawal penalties. With either a Roth IRA or Traditional IRA, anything withdrawn before the age of 59 ½ is considered ‘early’. There are no MRDs required during the original owner's life.
Approved withdrawals (after age 59 1/2) are not considered part of your taxable income. Therefore you will have some control over what tax bracket you will fall into in a given year during retirement.
So what combination makes sense for you?
There’s not one straightforward answer.
A good place to begin is by thinking about what your tax rate now is, and what you think it might be in the future. In principle, you’d want to select whichever of the two periods where the taxation is less.
Realize, though, that no one has a crystal ball. Speculation about future tax rates is really just a guess.
Other’s might want to look at their current tax bracket. If your income is high enough to push you into a higher tax bracket, using a Traditional IRA could reduce your taxes. It could reduce your taxable income and hence your tax rate. This is true assuming you crossed the threshold back into the lower tax bracket.
On the other hand, if your workplace uses a workplace plan like a 401(k) or 403(k), your traditional IRA contributions may not be fully tax deductible.
Consider that during retirement, having both would give you sources of income that are taxable and non-taxable. You could alternate between withdrawing from your Roth IRA or Traditional IRA to ensure you are in an ideal tax bracket. Being required to withdraw a MRD can be a nuisance - you’ll stop earning interest, and frankly, you might not have an immediate need for the cash.
A few other considerations to to keep in mind
Remember to invest your IRA funds
There is a deadline to contribute funds to your IRA, but don’t forget that you can move those funds around. Dropping and leaving the funds in cash equivalents means your money is not working for you. Take advantage of the compounding interest that other investment vehicles offer. Stocks, bonds, and mutual fund are just scratching the surface.
That of course gets into a broader conversation about risk tolerance, time horizons, and portfolio diversification. Whether managing these yourself or paying a professional, there will still always be bull and bear markets. It can be stressful for novice and experienced investors alike - your emotional resilience should play a part in your decisions.
If your spouse doesn’t work, he or she can contribute to a spousal IRA so long as you are working and the two of you file your federal income tax return jointly. The IRA can be either a traditional or a Roth IRA, and the contribution limits are $5,500 for those under 50, and $6,500 for those 50 and older.
Converting retirement accounts into A Roth IRA
There are a number of reasons why you might consider converting accounts at some point in the future. It’s a potential part of inheritance planning. Or maybe you want to continue to work and contribute well past retirement age. Some people convert 401(k) accounts when they move on to a new employer. Keep this option in mind, it may be handy at some point down the road.
Don’t get locked in the notion that you have to pick a Roth IRA or Traditional IRA. They are all useful tools in the retirement planning toolkit. Educate yourself on your options, do a little scenario planning, and pick the combination that best suits your needs.