The Main Event: Should You Choose a Traditional or Roth IRA - or Both?
Citi Personal Wealth Management
In 2018, you can put a maximum $5,500 in all IRAs combined, or $6,500 if you're age 50 or older. With a Traditional IRA, you might get an immediate tax deduction, but all withdrawals are taxable as ordinary income. Meanwhile, with a Roth IRA, there's no immediate tax deduction, but all withdrawals in retirement can be tax–free.
You may also face this choice within your employer's retirement plan, where you may be able to opt for the Traditional 401(k), with your contributions coming out of pretax income, or you can go for the Roth 401(k), which is funded with after–tax income. Income levels do not determine whether you must choose between one or the other. It's a personal preference that you should review with your tax professional.
Here's a brief overview of some factors to consider:
Out of your hands
For those who can't decide which IRA is better, here's the good news: You may not have a choice.
If you aren't covered by a retirement plan at work and you have sufficient earned income, you are always eligible to fund a Traditional IRA, no matter how much you make. But if you are covered by your employer's retirement plan, you may not be able to deduct all or any amount of your Traditional IRA contributions if your income is above the allowable threshold.
Meanwhile, with a Roth IRA, it doesn't matter whether you are covered by a retirement plan at work. Instead, all that matters is whether your income falls below the threshold for eligibility.
For instance, in 2018, if you're single and covered by a retirement plan at work, you can only fully fund a tax deductible Traditional IRA if your modified adjusted gross income is $63,000 or less. But you can fully fund the Roth as long as your income is less than $120,000.
Weighing the choice
Still, let's assume you need to choose between a tax–deductible IRA and Roth account, either within your employer's plan or when making your annual IRA contribution.
If you expect your tax rate to be lower in retirement, deductible retirement accounts, like the Traditional IRA, would provide you with a tax deduction today when you're in a higher tax bracket, while putting off taxes until retirement when you hope to pay Uncle Sam at a lower rate.
Conversely, if you expect to pay taxes at the same or a higher rate once retired, you would pass up today's tax deduction with a Roth IRA to get what should be tax–free withdrawals in retirement.
What if you aren't sure? You could hedge your bets. Just as you can diversify your portfolio by purchasing a slew of different securities, you might also diversify your tax risk by funding both tax–deductible and Roth accounts.
While future tax rates often drive the tax–deductible vs. Roth decision, the Roth offers four additional advantages that you may want to consider.
First, $5,500 saved in a Roth IRA is worth more than $5,500 saved in a Traditional IRA, because you will eventually have to pay taxes on your Traditional IRA. To be sure, you enjoy initial tax savings when you fund a Traditional IRA. That can even the score with the Roth, but only if you make a point of adding those tax savings to your retirement nest egg.
Second, Roth IRA accounts offer flexibility. For instance, your regular annual Roth IRA contributions can be withdrawn at any time for any reason. Just put $5,500 in a Roth IRA. You can pull your $5,500 out tomorrow, with no taxes owed. It's only if you touch the account's investment earnings that taxes and penalties are potentially an issue.
Third, unlike with a Traditional IRA, you don't have to take required minimum distributions starting at age 70½ from a Roth IRA. That means you could leave your Roth IRA intact to continue growing tax–free and possibly even bequeath the entire account to your heirs.
Finally, a Roth IRA can make a fine inheritance. Nonspouse beneficiaries of both Roth and Traditional IRAs are required to start taking minimum annual withdrawals soon after inheriting. But while your beneficiaries will have to pay income taxes as they draw down your Traditional IRA, they won't owe taxes on your Roth IRA. Indeed, if your Roth IRA beneficiaries are careful, they could enjoy years of tax–free growth out of the account.
Trying the backdoor
You may discover that you aren't eligible for either a tax–deductible or Roth IRA. That means your only choice is a nondeductible IRA, which will still provide tax–deferred growth but no tax deduction. When you draw down the account in retirement, you will have to pay income taxes on the account's investment gains, though you won't owe taxes on the dollars you originally contributed. You may also want to consider whether converting some of your Traditional retirement accounts to a Roth IRA may benefit you.
Remember, before you make any decision, you should consult a tax advisor.
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