The Roth IRA vs IRA debate, like most personal finance subjects, is unique to each individual. Everyone’s situation and financial circumstances are different, therefore there aren’t any cookie cutter solutions. The decision begins with understanding Roth IRA vs IRA debate, and when it makes sense to contribute to one or the other.
Roth IRA vs IRA
Benefits of a Roth IRA
Roth IRA’s are an after-tax account. This means when you contribute funds to a Roth, you’ve already paid taxes on that money. An added benefit of paying taxes now on the funds is they grow within a Roth tax-free. Once you’ve reached retirement age, the funds in a Roth can be withdrawn from the account without paying any taxes!
The benefits of tax-free growth are enormous, especially if you expect to be in a higher tax bracket in retirement. For example, many young professionals should consider a Roth because they’re likely not close to their peak earning years and are paying lower taxes than they will be late in their careers and in retirement. If you can pay taxes now, at a lower tax bracket, there’s the potential for tremendous savings when you go to make withdrawals 30-40 years from now.
There’s also an income limit on Roth IRA’s. Once you pass $135k and $199k in income if your single or married respectively, you’re no longer able to legally contribute directly to a Roth IRA. There are some workarounds to this rule, however.
First, find out if your employer offers a Roth 401(k). Most employer retirement plans have added a Roth provision, and there are no income limits associated with being able to contribute to a Roth 401(k). If you leave your employer, the Roth portion of the 401(k) can simply be rolled into your Roth IRA.
Second, if you don’t have access to a Roth 401(k), you can consider a backdoor Roth. The backdoor Roth strategy involves making a contribution to an IRA, then completing a conversion to a Roth. Although the specifics around this strategy can be a little murky, it’s important to consult with your advisor or tax planner before doing so.
Lastly, the Roth IRA contributions can always be taken out tax and penalty free. Since taxes have already been paid on your contributions the government doesn’t penalize you for taking them out. However, it’s typically not a good idea to withdraw funds from a Roth once you already designated them as a long-term investment towards retirement.
Benefits of an IRA
Traditional IRA’s are a pre-tax account. This means when you contribute funds to an IRA, they’re not counted as part of your income for that year. If you’ve made 100k this year and made a contribution to an IRA of $5,500, then you’re only paying taxes on 95k (excluding other deductions and credits). The flipside is you’ll have to eventually have to pay taxes on the funds when you take distributions in the future. When you retire and go to withdrawal from the IRA, for example, you’ll pay ordinary income tax.
The benefits of an IRA are that you are reducing taxable income in the year you make contributions, thereby freeing up those tax savings to put to work elsewhere. The time value of money says that a dollar today is worth more than a dollar in the future. Therefore, if you’re able to save money on taxes today, it can be more beneficial than paying those taxes.
The caveat is whether or not you anticipate being in a lower tax bracket in retirement. If you’re currently in one of the top 3 tax brackets you’d save a lot more in taxes today than if you were in the bottom 4.
Traditional IRA contributions will benefit you most today if you are in a high tax bracket and/or looking to reduce your taxable income and in a high-tax bracket. In contrast, a Roth makes more sense if you’re in one of the lower 3 brackets. Another way to look at it is, if you’re expecting to be in a higher income tax bracket in retirement, a Roth is definitely the way to go. If you’re expecting to be in a lower-income tax bracket, the traditional IRA may make more sense.
For most young professionals, stockpiling as much money into a Roth while in lower tax brackets is the smart thing to do. You can always make the change to a traditional IRA should your situation change. However, the cap on Roth contributions makes contributing to one much harder and less accessible over time as your income grows.
Now that you understand the difference between a Roth IRA and traditional IRA it’s time to take action! Roth IRAs and traditional IRAs have a contribution limit of $5,500 a year in 2018. That’s a combined total. You can’t max out a Roth AND an IRA. However, if you’re married you can also make what’s called a “spousal contribution” to a Roth or IRA in your spouse’s name. Obviously, when you’re married, your finances are typically handled jointly and you’ve articulated financial goals together. Maximizing your retirement contributions through IRA’s are a great way to ensure your future selves are taken care of.
The best way to begin contributing to an IRA is similar to how you contribute to a 401(k) plan. We’d suggest setting up automatic contributions on the day of your paycheck. Even starting with a small amount, say $200 every two weeks. That adds up to roughly $4,800 in annual contributions. Over time you can ramp up the amount contributed until you hit the max. These small contributions will utilize the power of compounding, and before you know it, you’ll have accumulated another nice nest egg outside your employer-sponsored retirement plan.
If you need help determining whether a Roth IRA vs IRA is best for you, need help articulating financial goals and priorities with your spouse, or are interested in putting together a comprehensive financial plan, don’t hesitate to schedule a free consultation with us today.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!