Roth IRA vs. Traditional IRA: Which is Right for You?

Everybody wants to guarantee a secure future—especially when it comes to retirement. One of the things that can provide this security is savings. It’s never too early to START SAVING NOW!

But, where to even begin? If you work for a company or business, your employer may offer a 401(k) retirement plan. Some employers even match a portion of what you contribute to these plans. Be sure to take advantage of this important benefit!

Of course, not everyone has the luxury of an employer-sponsored retirement plan. More and more people are performing independent contracting and gig-work as the current job market is, well, pretty uncertain, to say the least. 

So how does one save for their retirement if there is no 401(k) available? Or if they feel they need more retirement cash than their 401(k) offers?

Individual retirement accounts (IRAs) provide a similar opportunity to save for the future. There are, however, different types of IRAs. Understanding the types of IRAs can help you plan for your retirement based on your current situation and future goals.

Let’s get started with the basics…

What is an Individual Retirement Account (IRA)?

An IRA is a special account set up by a financial institution like a bank, credit union, or brokerage firm. It provides the opportunity to save for your future and meet your retirement saving goals. These accounts offer tax advantages, unlike other savings accounts from financial institutions. In fact, the government offers incentives for individuals to adopt a proactive role in saving for their retirements. (But, more on this in a bit.)

IRAs invest your money to, ideally, make you much more money than a traditional savings account. In fact, a self-directed IRA allows you to invest in different combinations of stocks, bonds, CDs, mutual funds, and/or other assets. How you invest depends on your goals, when you’re retiring, and your personal preferences about taking financial risks.

For example, those who are pretty far from retirement may choose to invest in a portfolio that includes diverse stocks. Over the long run, stocks tend to have a pretty good return when compared to other investments. Of course, as we’ve seen this year, they can also be pretty volatile.  A large dip in the stock market right before you plan to retire can put a pretty big dent in your IRA savings.

A more conservative route, like investing your IRA portfolio in CDs or bonds, may not have as large returns compared to stocks. These are, however, stable investments that typically grow steadily.  

For many IRAs, you can change your investment preferences the closer you get to retirement. And, of course, the guidance of a certified public accounting professional can take some of the guesswork out of how you want to allocate your IRA contributions. 

Contributing to an IRA

Ready to start saving? You must have “earned income” if you wish to contribute to an IRA account. Earned income includes wages, salaries, tips, bonuses, commissions, and money from self-employment. 

But some types of income aren’t eligible including: 

• Child support
• Alimony
• Rental property income
• Dividends and interest from investment
• Social Security
• Unemployment benefits
• Retirement income

For 2020 and 2021, the contribution limits for IRAs are $6,000. If you are 50 or older, you can add another thousand dollars to your contributions. Roth IRA contributions (more on specific IRA types next), however, depend on your modified adjusted gross income or MAGI. If your MAGI is over $140,000 ($208,000 if married filing jointly) you cannot contribute to a Roth IRA.

Before you decide how you wish to invest the money you contribute to an IRA, you need to determine what type of IRA you want to open. Yes…more choices. Let’s take a look. 

Common Types of IRAs

There are two main types of IRAs available to most people wanting to save for retirement. One of the main differences is how and when you are taxed.

Traditional IRA

A traditional IRA is more like a personal pension. Your contributions are tax-deductible the year you make them. This can lower your yearly adjusted gross income (AGI), allowing you to qualify for other tax incentives or even placing you in a lower tax bracket.

You don’t pay taxes until you start withdrawing from a Traditional IRA during your retirement. Many retired people fall in a lower tax bracket compared to when they are working, so the tax burden is not as big.

Roth IRA

For a Roth IRA, you’re contributing with money after taxes. So, you’re not receiving a tax deduction when you make contributions—or lowering your AGI. 

That being said, when retirement rolls around, you won’t be required to pay taxes on your withdrawals. 

What Else Do You Need to Know About Roth vs. Traditional IRAs?

There are other important differences between Roth and Traditional IRAs you need to know before setting up your accounts. Here are some more things to consider…

Income Limits 

For a traditional IRA, anyone with earned income can contribute. That being said, a couple of factors play into your contributions being fully tax-deductible. This includes how much money you make and if you (or a spouse) is covered by an employer-sponsored retirement plan.

Roth IRAs have income-eligibility restrictions. For 2021, you need to earn less than $140,000 MAGI or less than $208,000 if married and filing jointly. Also, your contribution limits decrease if you earn more than $125,000 (or $198,000 if married filing jointly).

Distribution of Your Earnings

After all that saving, you should understand the rules of withdrawing your funds. For traditional IRAs, you are required to take required minimum distributions (RMDs)—taxable withdrawals—when you are 72 years old. At this age, even if you are still living comfortably, you need to draw from these funds.

Conversely, Roth IRAs have no RMDs. In fact, if you’ve made great financial decisions, there is no pressure to start using these funds. The benefit: you can transfer your wealth to loved ones if necessary. They won’t owe income tax on withdrawals—but they will need to take distributions or roll the account into another IRA. 

Accessing Money Before Retirement Age

Life is unpredictable. Circumstances may require us to pull from our retirement savings before we hit the age of 59 ½. For a traditional IRA, early withdrawals require you to pay taxes and a 10% penalty. 

Some circumstances negate the 10% penalty (but not the taxes) including:

• First-time home-buyer expenses (up to $10,000)
• Qualified higher-education expenses
• Disability
• Unreimbursed medical expenses

A Roth IRA is much more flexible if you’ve had the account for at least five years. Since you already paid taxes prior to contributions, you can withdraw sums equal to your Roth IRA contributions for any reason—even before you hit the age of 59 ½. There are no taxes or penalties associated with these withdrawals. 

If you want to tap into your earnings, however, you need to have the account for 5 or more years and:

• Be  59 ½ or older
• Become disabled or have certain qualifying hardships
• The money is withdrawn by a beneficiary after you die
• The withdrawal goes toward medical costs, qualified education expenses, or a first time home purchase 

Of course, whenever possible, you don’t want to touch the money in your IRA until you’re ready for retirement. This ensures the money you contribute has the most earning potential.  

Choosing your IRA

By now, you’re probably wondering which IRA is best for you. As you’ve seen, there are a lot of factors to consider. But let’s give a couple of scenarios and identify which IRA is a better option.

• If you think your tax bracket will be lower during your retirement years and/or don’t have the opportunity to participate in a workplace-sponsored retirement plan, a traditional IRA may be a good choice.
• If you believe you’ll be in a higher tax bracket during retirement or you may need access to some money before retirement (while not advised, but, well, life happens) consider a Roth IRA.  

Setting Up Your IRA

Hopefully, by now, you have a solid working knowledge of IRAs. Setting up an IRA is fairly simple—you can even set up some IRAs online.

But if you still have questions, you may want to consider talking to a financial advisor. After all, these decisions directly affect the stability of your future. In fact, a financial advisor knows strategies and hacks that could end up making you much more money in the long run. Especially when tax time rolls around…

Steven Lissner & Company has a team of experienced, responsive financial professionals ready to help you understand retirement saving and find the best options for your goals. With over 30 years in the business, those at Steven Lissner & Company have helped thousands secure a better future. 

Take a minute to request a financial consultation today. Your future self will thank you.