One of the key things we do is educate our clients on the different savings and investment tools available. One of the critical points of confusion we try to dispel are the strengths and weaknesses between Traditional and Roth IRAs. We often see clients who are entirely sold on one over the other even though the best retirement plans usually involve a mix of the two at different times in the income and savings cycle. Timing and planning are both critical aspects for determining when to use each vehicle.
What is an IRA to begin with?
IRA stands for Individual Retirement Account. IRAs are simply investment vehicles in which you can invest in stocks, bonds, mutual funds, etc. They work just like regular investment accounts, with the critical difference being how contributions and earnings within IRAs are taxed.
IRAs generally take two different forms: Traditional and Roth. A traditional IRA is built with funds on a “pre-tax” basis meaning income taxes aren’t paid on contributions going into these accounts. If you contribute to a Traditional 401(k) at work, the part of your check that goes into this account has not been taxed as income. If you make a contribution to a Traditional IRA, it works the same way by lowering your taxable income by the amount of the contribution. When and how much you can contribute to each plan is governed by the Internal Revenue Code.
A ROTH IRA uses “after tax” dollars. This means income tax has already been paid on the contributions being made. Contributions to a Roth will not lower your taxable income. However, unlike a Traditional IRA, the earnings on investments in a ROTH are not taxed when you take those funds out in retirement.
Why do these differences matter for retirement planning?
There’s a lot of nuance to the rules behind all IRAs. When it comes to understanding when and how to use Traditional and Roth IRAs, it’s best to focus on three things:
Impact on taxable income at the time of contribution and distribution
As we’ve established, the key benefit of Traditional IRAs is lowering taxable income during an investor’s working years. From a tax planning perspective, it always makes sense to stay in the lowest tax bracket possible. The strategy behind a Traditional IRA is shifting tax on income away from higher tax brackets in peak earning years into retirement when investors expect to have lower annual taxable income. However, given the changes in tax regulations that happen across decades, many nuances exist that make these strategies difficult to predict with 100% accuracy.
Though ROTH IRAs do not have an impact on income tax in the year of contribution, earnings and distributions from a ROTH in retirement will not impact taxable income in retirement. While this may change with revisions to the tax code in the future, there are many common circumstances where investors may be unable to realize any tax benefit at the time of contribution. In these cases, it makes sense to maximize the tax benefit of earnings from those contributions in retirement.
When distributions are required based on age.
With Traditional IRAs, investors are required to begin taking withdrawals starting at age 70½. These Required Minimum Distributions or RMDs are the key mechanism for collecting income tax on contributions and earnings that were not previously taxed. The portion of the account you’re required to withdraw varies with age and increases as the investor gets older. At 70½, the investor must take at least 3.65% of the assets within an IRA. In future years, that percentage rises 5% to 8% per year once the investor reaches their 80s, then finally moving to 8% to 14% per year in an investor’s 90s. For the average investor working today and saving for retirement, RMDs may not be much of an issue if the primary means of paying for living expenses comes from these IRAs and Social Security.
ROTH IRAs do not have a set schedule for taking distributions. While this may change under future revisions to the tax code, right now investors can pass down an entire career’s worth of ROTH IRA contributions and earnings to the next generation.
While flexibility of withdrawals is a key benefit of ROTH IRAs, many Americans are counting on their retirement accounts to provide for living expenses. In these cases, perpetual deferral may not be a benefit. On the other hand, this is a key benefit in cases where investors are certain they have more than enough assets necessary to cover living expenses across their lifetime.
Taxability of distributions
Every distribution from a Traditional IRA creates a taxable event. How much tax is paid on those distributions depends on the kinds and amounts of income generated in the rest of the tax year. Interest and Dividends, Pensions, Social Security and Medicare benefits along with Rental income or any other kind of income earned as an Employee or 1099 contractor will have an impact on how much tax is paid on those Traditional IRA distributions. This is before you factor in the effects of tax reform, such as the changes to Itemized Deductions, Dependents and filing status.
Retirees with ROTH IRAs have more flexibility to determine when or whether to take a distribution. Often, a retiree will return to work in a temporary or part-time capacity for a former employer. Sometimes families will rent out their primary residence while they’re on an extended vacation. An investment advisor may want to draw down gains on investments. Each of these events can bump taxable income into a higher tax bracket even before those Required Minimum Distributions come into play. The ROTH “bucket” can help manage the flow of retirement savings while smoothing out cash flow in retirement.
In conclusion: Retirement planning is complex
IRAs exist to help encourage taxpayers to save for retirement. Every kind of IRA can be a means for investing in a mix of stocks, bonds, mutual funds and other securities. Whether you have a ROTH IRA or Traditional IRA is irrelevant to what investments are used to grow retirement savings. Which vehicles to use and when depends on a variety of different factors depending on age, income level, life goals, tax law changes and employment.
Too often, taxpayers end up making these decisions when it comes time to file as opposed to setting up a plan and strategy that adapts to changes in circumstances. This is why it makes sense to seek the advice of professionals who are well versed in both investments and taxes when it comes time to choosing between Traditional and ROTH IRAs to maximize returns and minimize tax liability with retirement savings.