With all of the complexities of the financial world, you would think they could make at least one thing simple, right? Individual Retirement Accounts, or IRAs, seem like a good candidate. They are retirement accounts that aren’t tied to your employment, which greatly simplifies things. IRAs can be invested in just about anything but life insurance and collectibles, so there aren’t a lot of restrictions to convolute things (unlike 401k plans which limits you to a preselected group of investment choices)
IRAs seem like a simple, straight-forward investment option, right? Well, not so fast. Remember, this is the financial world, and simple is not part of the playbook. IRAs come in different flavors, and the two big ones are traditional or Roth.
Advantages Of Investing In a Traditional IRA
Life was simpler before 1997 when there was only one kind of IRA, which is now referred to as a traditional IRA. It is a tax-deferred retirement account, so it is funded with pre-tax money and the taxes are paid when money is taken out of the account in retirement. The great thing about using pre-tax money is that you have more money available to invest if you don’t have to pay taxes out of it first. Also, you could be in a lower tax bracket in retirement, so you may pay less in taxes than you would have if you had paid them upfront.
Advantages Of Investing In a Roth IRA
Senator William Roth sponsored the Taxpayer Relief Act of 1997 which created the Roth IRA. There are a few key differences between Roth IRAs and traditional ones. The biggest difference is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front (your contributions are made with after-tax dollars), but you get tax-free withdrawals in retirement (after the age of 59-½). In other words, once you invest your after-tax dollars in a Roth IRA, you don’t have to pay taxes on any of the growth.
Another big difference is that there are no required minimum distributions. You can leave your money in the account to grow forever, instead of being required to start taking withdrawals (and stop contributions) at age 70 ½ like with a traditional IRA account. This can be used as an estate planning tool to provide tax-free income for grandchildren and future generations.
One often overlooked benefit of Roth IRAs is that you can withdraw your contributions (not your earnings) at any time and for any reason. For example, let’s say when you were a 30 you decided to put in $5,000 into a Roth IRA. Let’s say it’s a decade later, and that money has grown to $10,000. You still have penalty-free access to that initial $5,000 you contributed, should the need arise. That flexibility is a nice perk for Roth IRA accounts.
The one restriction is that there are income limitations to qualify to use a Roth IRA. In 2017, singles making over $133,000 cannot contribute to a Roth and the amount they can contribute begins phasing out after $118,000 of earnings. The phase-out period for married tax filers is $186,000-$196,000.1 However, anyone can convert a traditional IRA into a Roth through a “backdoor conversion.”
Which Type Of Account Is Right For You?
Because of the different tax treatments, a Roth IRA is almost always better for younger people who have more time to save and take advantage of compounding interest. If you are nearing retirement and will need the money early in retirement, you may be better off with a traditional IRA. Many people choose a Roth regardless of their age so that they won’t be required to take distributions and they can leave the money to their families. If you make too much money to be eligible for a tax deduction for a traditional IRA you are better off with a Roth, though you will have to do a “backdoor” conversion to open one.
If you are rolling over an old 401(k) to open your IRA, the type of account you choose will have considerable tax implications. You won’t have to pay any taxes to roll a traditional 401(k) into a traditional IRA, but to roll it into a Roth you will have to pay taxes on the entire account. If you don’t have extra money to pay the taxes, you may be limited to a traditional IRA.
How I Can Help
Which kind of IRA is best for you depends on your personal situation and preferences. When making important financial decisions like this, it always helps to talk to an experienced professional who can help you understand your options and the implications of different choices. If you are considering investing in an IRA, schedule a quick phone call now here. I can help you choose the best IRA to fund your specific retirement goals.
For many people, a 401k is their largest retirement account. It deserves your undivided attention. Download our Ultimate 401(k) Guide for a step-by-step strategy to master your 401(k), including a prioritized checklist. It’s free!
Pathway founder and principal Greg Brown is a fee only financial advisor with broad financial planning and investing expertise. Greg’s financial advice has been featured in publications like Yahoo Finance, Bankrate, Investopedia (all articles here), Wall Street Journal, and USA Today. He holds a master’s degree from the University of Chicago and a mechanical engineering degree from Michigan State University. Prior to Pathway, Greg was a lead analyst at Morningstar and previously held engineering roles at Dell (including a US Patent).
Also published on Medium.