Traditional vs Roth IRA: What type of contribution should you make? Both offer unique advantages: it’s not always easy to decide.
If you’re an employee and have both a traditional (pre-tax) and Roth option in your employer's retirement plan, you’re faced with a similar decision. If your employer’s plan only has a traditional option and you want to diversify the way you save for retirement with a Roth IRA, your dilemma is also the same.
What type of contributions should I be making - traditional (pre-tax) or Roth? Remember: Roth IRA (Post-Tax) = 100% tax free withdrawals (if qualified). Traditional IRA (Pre-Tax) = 100% taxable withdrawals.
Traditional IRA earnings accrue tax deferred, not tax free like a Roth. Tax on yearly contributions is also deferred, earning the taxpayer a tax deduction in the year of the contribution. 100% of all distributions (contributions + earnings) are taxed at ordinary income tax rates upon withdrawal.
Roth IRA earnings accrue tax free, not tax deferred like traditional pre-tax contributions. Since earnings accrue tax free, and tax has already been levied on the contribution, 100% of all distributions (contributions + earnings) are tax free upon qualified withdrawal.
A taxpayer benefits more from traditional contributions in the year the contribution is made. Everything else being equal, making a pre-tax contribution versus a Roth contribution will generate a higher net income in the year of the contribution because of tax savings. The higher your tax bracket the bigger the savings.
Roth IRA savers benefit more on the back end when qualified withdrawals are made. Tax has already been levied on the contribution and there is no tax on earning, making qualified withdrawals 100% free of taxation.
When comparing traditional vs Roth IRA, realize these are two separate accounts. Given their unique saving characteristics, monies cannot be commingled. However, contributions can be made to one or both accounts in any given calendar year, but the total combination contributed cannot exceed the contribution limit for the calendar year.
Many savers maintain both a Roth IRA and a traditional IRA, often at the same financial institution, making contributions to one, both, or a combination of the two in any given tax year.
Money can be moved from a traditional IRA to a Roth via a Roth IRA conversion; however, tax must be paid – at ordinary income tax rates – on the entire amount converted in the year the conversion takes place. Money cannot be converted from a Roth IRA to a traditional IRA.
Traditional IRAs were originally created for employees whose employer didn’t offer a retirement plan. If you are self-employed or your employer doesn’t offer a retirement plan, it doesn’t matter how much money you make. You can make contribution(s) up to the yearly contribution limit, despite your income.
If you participate in your employer’s plan, however, there are income limitations which determine whether you can make a fully deductible contribution to a traditional IRA.
Why all the restrictions? It’s all about Uncle Sam getting his tax money! He doesn’t want you getting too many tax deductions, which of course limits his tax revenue for the year.
Roth IRAs, on the other hand, were created to be an additional savings vehicle for retirement. It doesn’t matter whether you’re an active participant in your plan at work or not – there is just one set of income limits for Roth IRAs that determine if you can contribute directly to it.
The Roth IRA income limits are substantially higher than for traditional IRAs, so most employees who have a plan at work can invest in both their company’s plan and a Roth IRA.
What if your income exceeds the limits for making a direct Roth IRA contribution? No problem. You can still get money into a Roth IRA. It just takes one extra step.
Time for what I like to call the ‘ole Roth IRA Switcheroo – you’ll be accumulating tax free earnings in no time! It may sound sneaky but it’s perfectly legal and legit.
That leaves the traditional vs Roth IRA contribution dilemma: If I can contribute to both, what type of contribution should I make? The answer may be all Roth contributions, all traditional contributions, or a combination of the two. It depends on your age and tax bracket.
Let’s say you’re twenty-one and just getting started in the workplace. You’ll want to make all Roth contributions.
Unless you’re a professional athlete or Hollywood movie star, you’re probably in a lower tax bracket at this point. It just makes sense to get that tax liability over with while it’s so low. Plus, your time horizon for investment is extremely long (around 45 years), so lots of earning can be expected, making the choice a no brainer.
Instead, let’s say you’re in your 60’s, at the top of your pay scale at work, have two kids in college, and plan on retiring soon. You’ll probably want to make traditional contributions.
That tax deduction is more valuable than ever, now that you’re in a higher tax bracket. Making a Roth contribution at this point costs you big bucks, which you need to pay for your kids’ tuition. Finally, because you’re retiring soon, earnings will be limited, thus reducing the utility of tax free earnings.
Traditional vs Roth IRA contributions? Your choice most likely lies somewhere in-between. Some years it will be clear cut which type of contribution to make, while in others it will be more muddled.
That’s why the best solution is to have both a traditional IRA and a Roth IRA. That way you can have both a taxable and a non-taxable source of income in retirement, diversify the way you’re saving, and protect against unforeseen tax rate increases.