So you’ve got a little cash saved in the bank, you have your debt under control and you feel like it’s definitely time for you to start looking into stashing away some extra money for your future retirement. Time to decide, Traditional or Roth IRA?
Maybe you have a 401(k) from your job, or maybe you have a brokerage account and you’re used to managing your own investments. Regardless of their financial situation, many people look to their IRA as a flexible place to stash money away for their future and now it’s time to think about starting one of your own. Congrats on making the decision, wise choice.
Here’s the question, though, which type of IRA should you choose? Should you go the traditional IRA route or elect for a Roth IRA option? Believe it or not, this is a very common question.
In order to make the best decision for yourself, it’s definitely worth understanding the key differences between the traditional IRA and a Roth IRA, so read on, because this decision is actually a pretty simple choice to make for yourself if you have the facts.
Before we get into the nuts and bolts, I have to put a disclaimer out there. There is no right or wrong answer to the traditional vs. Roth question. There are many people who have a very strong opinion either way on which option YOU should choose but they have not walked a mile in your shoes.
Ever heard the saying “different strokes for different folks”? That definitely applies here. Everybody’s financial situation looks different, so don’t let that on-air personality (I’m not going to name names) tell you that you should be doing the exact same thing that every one of their viewers or listeners should.
Pick up a book about the traditional IRA and why it’s the best, read 300 pages and then make up your mind. I assure you that another book on the same shelf with the same amount of pages about a Roth IRA may be just as convincing. The only way to know which choice is the best for you is to understand what makes the traditional and Roth IRA different and how to weigh out those differences against how you feel about money.
Two schools of thought, one perfect analogy
Put quite simply, the most notable difference between the traditional and Roth IRA has to do with how your money is taxed. Unfortunately, there’s no way to avoid paying taxes (most of the time) so the real important question becomes would you like to pay tax now or would you like to pay tax later?
It’s as simple as that for starters, allow me to explain.
Imagine you want to start a farm. Your plan is to take some money that you have saved and head down to the seed store, buy up a bunch of seeds then plant your freshly plowed fields, water as necessary and wait for a bountiful harvest… Do you see where I’m going with this?
I choose to pay my tax later. The Traditional IRA
What if you arrived at the store to purchase your seeds and the salesperson behind the counter (we will call him the “Seed Broker”) tells you that there are actually two different options for paying tax on your seeds.
The first tax option for buying seeds is paying tax later. In this scenario, the Seed Broker tells you that when you make this purchase there are no taxes due. This means that you can walk out of that seed store with a bunch of seed that you don’t have to pay tax on right now. In addition to not having to pay tax at the time of purchase for your seeds, the seed broker tells you that when it comes time to pay taxes for this year, you can deduct the amount of money you spent on the seeds (to a certain limit) from your income for income tax purposes.
This is a great analogy for the traditional IRA. The money that you fund into a traditional IRA is considered pre-tax money. This means that money placed into your IRA is actually tax-deductible the year that you make the contribution. In 2016 the current limits for contributing to an IRA are $5500 or $6500 if you are age 50 or older (the $6500 being what’s known as a catch-up contribution).
Next, the Seed Broker tells you that during the time your seeds are growing into what you hope to be a much larger harvest in the future, you’re also off the hook for taxes. In fact, the seed broker tells you that as long as you don’t harvest any of your crops, you can continue to defer taxes indefinitely. He does tell you, though, that once a specific date further down the road arrives, you will have to take at least a little bit of that harvest out because the way taxes are collected in this scenario is that they are due when you harvest your crop.
That’s right, you have delayed paying taxes on your seeds that have grown into a much larger harvest (hopefully) in the future.
Remember I told you that taxes are pretty much unavoidable? Well here’s where the powers-that-be get the cash in. You’ve avoided taxes on the seeds that you bought, you’ve avoided taxes on the growth of your crop, but every single vegetable, grain or whatever else you’ve planted and spent all this time nurturing is counted as income for you and is subject to income taxes as soon as you harvest it.
Again, this is a perfect analogy for the traditional IRA. Any monies (up to the applicable limits of $5500 and $6500) that you contribute to your IRA are potentially tax-deductible, depending on your modified adjusted gross income and if you contribute to an employer-sponsored plan .This means that the money you contribute into your IRA account actually makes your income smaller on paper when it’s time to do your taxes. This tax deduction could result in less taxes being owed at tax time or potentially more money coming back to you depending on your individual situation.
Between a husband and a wife or same-sex couple both fully funding traditional IRAs, this could mean up to a $13,000 tax deduction per year combined between the two of them.
There’s also something to be said for having more money in your investment accounts earlier as opposed to later. The more money you have invested, if you’re successful at investing, of course, the higher chance you have to grow your money into a larger amount in the future. It’s just math. This is a big advantage to the traditional IRA … not paying tax up front and being able to defer your gains from taxes. You now have the opportunity to lock in that much more growth that you would potentially be paying taxes for in your other types of investment accounts.
One thing to always remember about the traditional IRA, though, is the rule that states you must take out Required Minimum Distributions or RMD’s starting at age 70 ½. So the one drawback (or at least that’s how some people consider it) to the traditional IRA is that you cannot defer taxes on your invested money indefinitely, eventually, Uncle Sam wants to take his piece of the pie because you haven’t been technically taxed on that money yet.
I choose to pay my tax now. The Roth IRA
The second tax option that the seed broker gives you is a little simpler. You have to pay tax right away. So yes, if you spend $5500 or $6500 on seeds you’re not actually going to be going home with $5500 or $6500 worth of seeds because you have to pay a little bit of tax based on your current income up front.
The seed broker assures you, though, (because he is so darn knowledgeable!) that once you pay that small amount of tax on the seeds you’re off the hook for taxes moving forward. He goes on to explain that the growth of your harvest is not taxed and when you decide to harvest your crop you won’t have to pay taxes at that point either.
One other advantage that your knowledgeable seed broker points out to you is also that since taxes have been paid upfront, there’s no set date in the future for when you have to take the money out. This means you could leave your Christmas tree farm of a harvest in the ground until it turns into a Christmas tree forest if that’s what you want to do. No one is going to make you harvest your crop until you’re ready.
This is the Roth IRA in a nutshell, and it can be a powerful vehicle because although you have to pay income tax up front on the money you contribute, you don’t have to pay tax on the growth of the IRA nor do you have to pay on withdrawals once you retire.
And as previously mentioned, since you have already paid tax upfront in your Roth IRA, the age 70 ½ Required Minimum Distribution rule does not apply. You’re welcome to let your money sit in the Roth until you decide to take it out. Some families actually pass a Roth IRA on as an inheritance to a family member. The tax benefits to this type of planning are definitely real and serve as an incentive for many people to take advantage of.
It pays to have a plan
The choice between a traditional IRA or Roth IRA is definitely one to put some thought into. I have found that when talking to people in terms of the analogy with the seeds, it usually gives them a much better idea of what would personally work best for them.
One other difference that I didn’t discuss earlier actually has to do with the Roth IRA’s income limits. That’s right, if you make too much money it’s actually against the rules for you to contribute to a Roth IRA.
Currently, in 2016, the income limits to fund a Roth IRA for single tax filers are set to start phasing out your ability to contribute once your income passes $117,000.
Beyond this level you lower the amount you can contribute to the point where you are off-limits for contributions if your income is higher than $132,000. For married couples or domestic partners, the phasing out of your ability to make contributions starts at an income of $184,000 and completely shuts off if your income goes above $194,000.
There are many factors to consider when deciding which type of IRA is right for you, there are also a lot of other options out there such as 401(k)s, Simple IRAs and SEP IRAs to choose from depending on your employment situation. Don’t let the different options intimidate you, I know there are a lot of them. Instead, just focus on the type of tax treatment you want and that should allow you to cut through a lot of the fat of your available options.
If you are interested in opening an IRA, you can set one up yourself using a variety of online brokerage platforms or work with a qualified financial advisor or broker who can help you put one together.
Good Planning, Good Saving, and Good Investing!
Success with money takes smart planning.
I’m Josh and I want to help you save more, be debt free, retire sooner, and stay retired!
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