roth ira

Retirement Planning: Roth IRAs vs. Traditional IRAs

When you start thinking about retirement, it’s important to carefully consider the type of IRA you choose to open. Your risk tolerance, income, and investment goals can all help to determine if a Traditional IRA, Roth or even a Self-Directed IRA is the best fit for you. We encourage everyone to speak with a fiduciary financial advisor before making this decision.

Roth IRA vs. Traditional IRA

The primary way the IRS differentiates between a Roth and Traditional IRA is when you pay taxes: now or later. Let me explain:

For a Traditional IRA, anyone under the age of 70 ½ and who is earning income, can contribute $5,500 each year to their individual retirement account. Those who are over 50 can contribute $6,500 per year. These contributions are often tax-deductible – depending on your income and other various factors. When you take distributions from this account, it will be taxed as ordinary income.

The exact opposite is true for a Roth IRA. All contributions to a Roth IRA are made after taxes are paid on your income. It’s important to remember that Roth contributions are not tax deductible. That said, when you’re ready to take distributions, most withdrawals are not taxed.

The other major difference between these types of accounts is distributions. Traditional and Roth IRAs allow you start taking distributions at age 59½ without penalties, however, if you take a withdrawal less than five years after the first contributions were made, the Roth IRA loses its tax-free status. Traditional IRAs require you to take minimum distributions annually, starting at the age of 70½. Roth IRAs, on the other hand, have no required distributions. If you don’t need the extra income, it can stay in your account and continue to grow. This is a great strategy, especially if you want to set up an inheritance for your heirs.

Benefits of a Roth IRA

At a quick glance, paying taxes “now or later” might feel like an either/or option. However, we encourage you to take a closer look. There are potential tax and estate planning advantages that might suggest a Roth IRA is a better option. Here are three reasons why:

1.    Tax Advantages

With traditional IRAs, account owners end up paying taxes sooner or later on their contributions and on their investment returns. A Roth IRA requires the taxes to be paid up front when the contribution is made. Because of this, Roth IRA holders see tax-free growth on all their investments. Learn how you can make direct distributions to qualifying charities to save on taxes. 

2.    Penalty Avoidance Benefits

Apart from a few exceptions, distributions from a traditional IRA cannot be made before the age of 59½, without penalty (along with the taxes you will already pay). With a Roth IRA, as long as your contributions have been in the account for at least five years, the contribution can be withdrawn without taxes or penalties—even before the age of 59½. Take note, however, that early withdrawals of investment returns are still subject to a penalty through a Roth account.

3.    Estate Transfer Benefits

Annual distributions are required for all traditional IRAs after the age of 70½, even if you don’t need the extra money. On the other hand, with a Roth IRA, there are no mandatory distributions. In fact, if you never need the money in your retirement account, it could even be passed down to your heirs. They can spread out their own tax-free distributions over any length of time.

Opening a Roth IRA and Working Around the Income Limitations

Most anyone can open a Roth IRA, simply by declaring the account a Roth from the beginning. All you need to do is find an investment firm or fiduciary financial planner who offers Roth IRAs.

Unfortunately, most high-income taxpayers quickly find out this option is not available to them. Individuals with an adjusted gross income (AGI) of $135,000 or more, and married couples filing jointly with an AGI of $199,000 or more are unable to make contributions to a Roth IRA. On the bright side, there is a work around. It’s possible for these high-income clients to create a Roth IRA through an IRAconversion. We call this the “back-door method.”

There are 2 common ways to approach this method:

  1. You put money into a traditional IRA, usually through a contribution. Anyone earning an income can make contributions to a traditional IRA. The only disadvantage for people with higher incomes is that their contributions are not tax deductible. Because the goal of the back-door method is a conversion to a Roth IRA, paying tax on contributions is unavoidable.

  2. You transfer money from a 401(k) or another employer compensation plan. This is what we call a Rollover. Rollovers are not under the same constraints as the regular IRA contribution thresholds of $5,500 or $6,500. So, your entire 401(k) or pension fund can be transferred in one transaction. Easy, right?

Once you choose your back-door method and your traditional IRA is set up, you can convert to a Roth IRA. These conversions are no longer limited by income; current laws allow anyone to use this back-door approach. In fact, the Tax Cuts and Jobs Act of 2017 approves the use of this approach.

Potential Risks of a Roth IRAs

The primary risk that comes with a Roth IRA is the unpredictability of future investment values, tax rates, and regulations. For example, should the investments of a Roth IRA drastically drop in value, you might regret paying taxes up front. 

In the past, Roth IRA holders were able to escape this outcome through a recharacterization—basically an IRA “backspace” button. Unfortunately, under the 2017 tax reform, recharacterization was outlawed and the terms no longer apply. Since this change, many investors approach the conversion to a Roth IRA with more consideration. Talk with your fiduciary financial advisor to ensure the best possible outcome on your IRAs.

Conclusion

Looking at the facts, the tax and wealth management advantages of a Roth IRA drastically outweigh the cons. Discuss the best course of action to take with your fiduciary advisor and your accountant. While IRAs potentially might benefit you, you still ought to consider carefully which IRA will best work for you as you plan for your retirement years.

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