Roth vs Traditional IRAs: Which Is Right for Your Retirement?
- Roth and traditional IRAs may be effective retirement-savings tools, but eligibility limitations apply.
- Taxes are due at the time of an IRA conversion, so be sure you have the funds to cover them if you take this step.
- A Roth IRA may be a good choice if you expect to be in a higher tax bracket in retirement, and it may provide estate planning benefits.
A traditional IRA is a tax-deferred retirement account that allows you to pay taxes at the time of withdrawal rather than at the time of contribution. Because withdrawals are taxed down the road, you have more cash up-front potentially growing over time. Contributions may also be tax deductible, making traditional IRAs an attractive option for investors who expect to be in a lower tax bracket during retirement.
The Roth IRA, on the other hand, provides no tax deduction for contributions. However, your investments benefit from tax-free growth and withdrawals, making the Roth IRA attractive to those who expect to be in a higher tax bracket down the road. In addition to the potential income tax advantages, a Roth IRA may provide estate-planning benefits and there's no need to take required minimum distributions (RMDs) once you reach age 70½.
Roth IRA contribution limits for 2015
For this tax year, the maximum amount that you can contribute to a Roth IRA is $5,500 (or $6,500 if you're age 50 or older). However, if you're single, your ability to contribute to a Roth IRA phases out for modified adjusted gross incomes (MAGI) between $116,000 and $131,000. If you're married and filing jointly, contribution eligibility phases out between $183,000 and $193,000 MAGI.
Traditional IRA contribution limits for 2015
Money put into a traditional IRA is generally tax-deductible, unless you're an active participant in a qualified employer plan like a 401(k). In that case, your traditional IRA contribution is fully deductible if you're a single filer and your MAGI is $61,000 or below. However if you're married and filing jointly, it phases out between $98,000 and $118,000 (and between $183,000 and $193,000 for the nonparticipant spouse of an active plan participant when filing jointly).
A note about nondeductible contributions to traditional IRAs
With today's historically low long-term capital gain and qualified dividend rates, a nondeductible contribution to a traditional IRA rarely makes sense. There's no up-front deduction and earnings are taxed at higher ordinary income rates when withdrawn. With a deductible traditional IRA, distributions are taxed at ordinary rates, but you receive an up-front deduction.
So if you do qualify for a deductible traditional and a Roth IRA, how do you choose between them? Here are some rules of thumb to help you make a decision:
- If you think your tax bracket will be higher when you retire than it is today, you should probably consider a Roth IRA—especially if you're a younger worker who's yet to reach your peak earning years. In the table below, you can see that the Roth is better when your marginal rate at the time of withdrawal is the same or higher compared with your marginal rate at the time of the initial contribution.
Roth and traditional IRA, now and in retirement
|Marginal rate now: Projected marginal rate in 25 years:||25% Higher: 30%||25% Same: 25%||25% Lower: 20%|
|Traditional deductible IRA - tax at withdrawal|
|Roth IRA - opportunity cost1|
|Not eligible for either a Roth IRA or a traditional deductible IRA? A nondeductible contribution to a traditional IRA may be counterproductive:|
|Traditional nondeductible IRA - tax at withdrawal|
|Taxable account - tax at liquidation|
Calculations assume $5,000 starting balance, 8% tax-advantaged return, 7.7% taxable return and a lump-sum withdrawal in 25 years.2
- If you think your tax bracket will be much lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. In the table above, you can see that your marginal rate at the time of withdrawal would need to be about 5% less than a current assumed rate of 25% for a deductible traditional IRA to be the better option, all else being equal.
- If you think your tax bracket will be the same when you retire, it's almost a wash for income tax purposes. However, you aren't subject to minimum distributions with a Roth, and if you leave it behind when you die, your heirs can stretch out their own income-tax-free withdrawals.
Another advantage of a Roth IRA is that contributions may be withdrawn anytime for any purpose without tax or penalty. However, just because you can do this doesn't mean you should. The opportunity costs are high—taking money out of your Roth IRA means you may miss out on compounding interest. When you can put in only $5,500 for 2014, plus an additional $1,000 "catch-up" contribution if you're age 50 or older, taking out previous contributions may be hard—or even impossible—to make up.
If you change jobs, you have the option to convert a traditional 401(k) directly into a Roth IRA without having to roll it into a traditional IRA first. Just remember you must pay federal income tax on pretax contributions and earnings at the time of the rollover.
Roth IRA conversions
If you're ineligible for a Roth IRA, you might consider maximizing contributions to a traditional IRA so you can convert to a Roth. However, there are some caveats:
You can't pick and choose which portion of traditional IRA money is converted. The IRS looks at all traditional IRAs as one when it comes to distributions (including Roth conversions). Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. So making nondeductible contributions to a traditional IRA with the goal of later converting to a Roth IRA would likely work best if you have little or no existing deductible IRA balance to muddy the waters. Still, any earnings leading up to conversion would be subject to income tax (which, as always, is best paid from outside funds).
- High earners not eligible to make Roth contributions could make nondeductible contributions to a traditional IRA and then convert to a Roth immediately with no tax consequence. This could be repeated every year, circumventing Roth income limits on contributions. If this is what Congress intended, it would have just eliminated Roth contribution limits along with the conversion limit, so don't be surprised if Congress writes some sort of anti-abuse provision into the law at some point.
The bottom line
A Roth IRA can be a great long-term savings tool, so try to take advantage of these rules if you can. Just remember that tax laws are subject to change, so check out the IRS's Latest News page regularly for important updates. Also, be sure to talk with your accountant or other professional tax advisor about whether a Roth IRA makes sense for you.
I hope this enhanced your understanding of traditional and Roth IRAs. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 Another way to compare a traditional deductible IRA and a Roth IRA would be to assume that only $3,750 would be invested in the Roth ($5,000 minus $1,250 in taxes paid today). In that case, if marginal tax rates are the same today and in the future, ending after-tax balances would be identical at $25,682. For illustration purposes, however, we assume the full $5,000 would be invested in both types of accounts. To make it a fair comparison, we account for the fact that the $1,250 up-front tax savings could have been invested in a taxable account. In cases where the tax savings are not invested (for instance, when they are spent), a lower opportunity cost might be justified, which would make the Roth look even better by comparison. The opportunity cost is the up-front tax savings, based on current marginal rate, not invested when investing in a taxable account
2 Assumptions: The lump-sum withdrawal (liquidation) after 25 years will be taxed at individual income tax rates of 30%, 25% or 20% for the traditional deductible and nondeductible IRA; withdrawal will be tax-free for the Roth IRA. Long-term appreciation is taxed at the 15% long-term capital gains rate for the taxable account.
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