We often set out to purchase clothes, shoes, phones, etc. with the intent of finding the best fit. You may have felt that feeling, when you find something that feels like it was made just for you. We also know what it’s like on the other side — where you got what you were looking for, but not entirely. The product or solution seems off balance. The very same happens when investors decide whether to contribute to a Roth IRA, Traditional IRA, or both. Often the implications of the choice go unnoticed. Both plans are treated in such different ways by the IRS; this is the reason you must weigh your options carefully to find your best fit for now and in retirement. Here’s some good things to consider.
IRA Consideration #1: Understand how both IRA plans work
The first consideration is how plan works from a high level. A Traditional IRA is considered “pre-tax” even though you typically contribute to it with after-tax money from your paycheck. The idea is that you have written off your contribution from your taxes, received your deduction, and therefore the money is “pre-tax.” Your distributions (or withdrawals) will most likely be taxed as income in your retirement years. However, the Roth IRA (younger brother to the IRA?) is viewed as “post-tax.” This is because your contributions are made with after-tax money but are not tax-deductible in the year you make them. The benefit of Roth IRAs comes when you decide to retire and are not taxed one the withdrawals, principal, or interest.
IRA Consideration #2: Your time until retirement
Second, consider the time you have until you expect to retire. The common goal of both plans is to keep as much money in your pocket and work for your benefit, but your situation may guide which is a better fit. If you have a longer time horizon until retirement, you may benefit more overall from contributing to a Roth IRA — which is why many younger individuals are steered toward them. However, if you have a shorter time horizon until retirement and your tax burden is larger now during your income-earning years, a Traditional IRA is worth a look. This is mostly because you may estimate that your tax burden will be lower in your retirement years. Ultimately, you’re measuring the benefit of the tax deduction now in a Traditional IRA versus the tax-free savings on the return of a Roth IRA.
IRA Consideration #3: Income Limitations
You must also consider income limitations on either plan. Specifically, if your income reaches the limits that the IRS has set for Roth IRAs or Traditional IRAs, the tax benefit you would receive could be lowered or even phased out. For example, if you’re married and filing jointly, you will start to see reduced contribution ability with a Roth IRA after $196,000 modified AGI. Or, if you’re covered by an employer-sponsored plan and file jointly, your income limits for a full deduction is $104,000 modified AGI. If this is the case, there are still opportunities to participate through a method sometimes referred to as a “backdoor Roth contribution.”
The most important step? Getting started
The Roth IRA and Traditional IRA are both great plans. I strongly encourage you to discuss them with your financial advisor and tax professional to help evaluate your best fit. Remember, there’s a benefit just to getting started — it allows you to form a plan and then work to perfect it over time. Consider your tax situation and what you need to do to stay within the requirements of either plan. You can then continue to refine the process, further tailoring the plan for an even better “best fit.”
Please feel free to call me anytime if you need advice on your retirement planning and which IRA could be your best fit.
Information in this material is for general information only and not intended as investment, tax or legal advice. Please consult the appropriate professionals for specific information regarding your individual situation prior to making any financial decision.
Withdrawals from a Traditional IRA prior to age 59 1⁄2 may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 1⁄2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.