Traditional or Roth IRA? Choosing a Retirement Plan

Recognizing that saving for retirement is a must for anyone who wants to control their own financial destiny and avoid running out of money later in life, Uncle Sam offers a variety of tax incentives to encourage people to set money aside in a range of investment vehicles, individual retirement accounts (IRAs) being among the most popular.

The challenge for investors is deciding to which type of IRA to contribute. Are they better off putting money in a traditional IRA, a Roth IRA, or both? The answer to that question is, “It depends.”

“There are some general rules of thumb to help guide you, but it really is a very situation-specific decision,” explains Scott Arnold, a certified financial planner with G&S Capital in Englewood, Colo. For that reason, he suggests potential IRA investors discuss their options with a financial professional before investing in an IRA. To find a Certified Financial Planner™ (CFP®) professional in your area, check out the Financial Planning Association’s national database at www.PlannerSearch.org. The following FAQ can help frame that discussion:

Q. What are some of the key distinctions and similarities between Roth and traditional IRAs?

Here are five to keep in mind:

1. Traditional IRAs are tax-deferred vehicles, meaning distributions are taxed as earned income when they’re withdrawn. Roth IRAs work the opposite way: contributions are considered after-tax (that is, they are taxed on the front end as earned income, prior to landing in the account) and money comes out tax-free.
2. Contributions to traditional IRAs may be tax-deductible. The amount of the deduction (full, partial or none) depends on whether the person (or their spouse) also has made contributions to a work-based retirement plan like a 401(k).
3. In the case of Roth IRAs, contribution limits are lower for people whose income exceeds certain thresholds. No income restrictions apply to contributions to traditional IRAs. However, the tax deductibility of traditional IRA contributions may be limited for individuals (and couples) who also contribute to an employer plan.
4. With a traditional IRA, withdrawals before age 59½ may be subject to a 10% early withdrawal penalty unless an exception applies, such as to cover the cost of college tuition. Those withdrawals also are taxable as ordinary income. With a Roth IRA, the amount invested (the basis) can be withdrawn anytime penalty- and tax-free.
5. With traditional IRAs, the account owner must start taking required minimum distributions (RMDs) beginning at age 70.5 or face stiff penalties. No RMDs apply to a Roth IRA held by its original owner.

Q. How do current age and income factor into the decision?

The tax-deductibility of contributions to a traditional IRA means contributions lower a person’s taxable income, potentially putting them in a lower tax bracket, a key consideration come tax time.

Personal finance experts such as Arnold often steer younger clients toward Roth IRA contributions when their income (and thus their tax bracket as well) tends to be lower, so those contributions have longer to grow. Lower-income individuals and couples may also qualify for a retirement savings contributions tax credit for up to 50% of their contribution.

Q. How do a person’s current tax bracket and their expectations for future tax status figure into the decision?

Roth IRA contributions make sense for people who expect to pay taxes at a higher rate during the withdrawal stage (retirement) than they’re paying currently. Of course, this relies on a degree of speculation, as tax rules change frequently. On the other hand, if you think you will be in a lower tax bracket when you are ready to retire and take distributions, it may make sense to contribute to a traditional IRA.

When clients move from a low (15%) tax bracket to a higher (25% or more) tax bracket, it also can be wise to start contributions to a traditional IRA rather than a Roth to lower their taxable income and diversify the tax status of their retirement savings, explains Ben D. Gurwitz, a certified financial planner with Jim Oliver & Associates in San Antonio, Texas.

After age 59.5, it may also make sense for certain people to start taking penalty-free distributions from a traditional IRA in order to minimize RMD amounts — and associated income taxes — later, when they hit age 70.5. The goal is to manage retirement account withdrawals in order to avoid income spikes (and thus, income tax spikes), taking into account income from IRA RMDs and other sources like Social Security, pension, etc.

Q. Which type of IRA is best for people looking to pass wealth to beneficiaries?

For people to whom tax-efficient wealth transfer is a priority, a Roth IRA may be the best option, says Arnold, because a lack of RMDs allows the account holder to keep money inside the account so it has more time to grow before it transfers to beneficiaries.

Q. How important a consideration is tax diversification?

“It’s very important,” says Arnold, who recommends people maintain retirement assets in three categories: (1) tax-deferred accounts, such as a traditional IRA; (2) tax-free accounts, such as a Roth IRA); and (3) taxable accounts, such as brokerage accounts with stocks, bonds, etc.

Such an approach allows for maximum flexibility when it comes time to draw down from those accounts during retirement, says Andrew Weckbach, CFP, founder of Scaling Independence in St. Louis, MO.

Q. How much flexibility do you need with your IRA?

A Roth IRA account holder can withdraw account contributions (the basis amount) anytime, at any age, with no penalty, and can begin taking out earnings (above the basis) tax-free from a Roth after five years.

That’s one of the reasons Troy, Michigan-based certified financial planner Leon C. LaBrecque calls Roth IRAs “the Swiss Army knife of retirement tools.”

Were these tips useful? Check out our downloadable retirement brochure: Planning for the Stages of Retirement