The choice between contributing toward a Roth IRA or Traditional IRA is a great problem to have – it means you are seriously considering your retirement and taking steps to build your financial future. Congrats! Now, what’s the better option? A financial advisor’s favorite response is, “It depends”.
Taking a step back, it’s important you have a few other areas of savings in place. For example, are you taking advantage of your employer’s 401(k) matching contribution? Do that first – it’s like an instant 50% or 100% return on your investment (depending on how much they chip in). Also, more companies nowadays offer a Health Savings Account with a matching feature – does your job do that? Check into it if you don’t know. Finally, do you have an emergency fund set up? It’s good to have some money in an easy-to-access checking account for a rainy day (you can actually use a Roth IRA for this too!).
Once you have those boxes checked, we can move on to the next priority for savings – your Individual Retirement Account (IRA). There is of course a Traditional IRA and a Roth IRA. The decision of which to contribute to really comes down to your tax situation today versus in retirement. As a general rule, if you are in your peak earnings year during your career now, you probably are better off contributing to a Traditional IRA (we’ll explain why). If you are early in your career or are in a low-income year for whatever reason, a Roth IRA may be more optimal.
So what’s the difference? With a Traditional IRA, you get an immediate tax deduction on your contribution so long as your income is not too high. So you get a tax break today, but then the downside is you will pay taxes on your withdrawal during retirement. The idea is if your tax rate is higher this year, and lower in retirement, you capture that difference as extra savings. It’s tricky though because the IRS won’t let you take the deduction if your income is too high. If you can’t take the tax deduction, then a Traditional IRA really doesn’t have a ton of value. Also with a Traditional IRA, if you withdraw money early before age 59.5, you get slapped with a 10% penalty and you of course have to pay income tax on the withdrawn amount.
For the Roth IRA, there is more flexibility. You pay taxes today, but the account grows tax-free forever. An added benefit, the money you contribute can be withdrawn tax-free, penalty-free whenever you’d like. Say you are in your 20s and want to save for retirement, popping in $1,000 into a Roth IRA would be a great move. But then let’s say life happens, and you want to settle down and buy a house. If your Roth IRA had grown to $2,500, you can withdraw that initial $1,000 tax-free, penalty-free to help pay for or furnish the house, etc. Also with a Roth, you can make a very high income and still be able to take advantage of its benefits, unlike a Traditional IRA where you really have to watch your income.
Another reason why a Roth could be the better option – chances are your employer is helping you contribute to your retirement. All matching contributions and other retirement benefits (like a retirement/profit-sharing plan) are made in the form of pre-tax contributions from an employer (like a 401(k) match). So doing a Roth IRA on your own adds some ‘tax diversification’ to your retirement strategy – and that’s a good thing. Much like diversification from the standpoint of your investment selections, tax diversification helps to mitigate risks related to future tax policy. Nobody knows what Washington & the IRS will decide decades from now.
An additional difference is the mandatory withdrawals during retirement. With a Traditional IRA, you must begin withdrawing from the account at age 72. With a Roth IRA, there is no required minimum annual distribution. This is another benefit for the Roth over the Traditional since the Roth allows for great flexibility.
One more consideration is state income taxes – Michigan levies a 4.25% state income tax, so let’s say you earn money in Michigan during your working years, but then retire to sunny Florida where there is no state income tax. That would be a net benefit to getting the Traditional IRA tax deduction since you would avoid Michigan state tax, then not pay a state tax during retirement in a place like Florida.
There is a lot to consider in the Roth vs. Traditional IRA decision. Most importantly for you, it comes down to your tax situation today versus the future, your current income, and your current mix of retirement assets. It is best that you speak with TFC to help you make the best move and the right long-term strategy.
Here’s the point
- Be sure you are taking advantage of any ‘free money’ from your employer before contributing to a Roth or Traditional IRA; do you also have an emergency fund?
- Know the rules and benefits of a Roth and a Traditional IRA – there are quirks to each that could make either one a more optimal choice depending on your circumstance.
- Consider your future and tax diversification before making your contribution.
Action items
- Review the rules of both types of accounts.
- Sit down with TFC to help you make an informed decision and one that is more optimal to meet your long-term financial goals.
- Reward yourself for taking smart steps to build your retirement today – you are ahead of the game.
Featured Image by Nattanan Kanchanaprat from Pixabay