If you’re a retirement saver with the April 15th contribution deadline looming, trying to figure out whether traditional IRA or Roth IRA contribution makes more sense for you can be a little bit like trying to decipher what happened in the last episode of Lost. Roth or traditional IRA can be one of the more complicated personal finance decisions most people face, but it doesn’t have to be. Let’s take a look at what variables you should be considering if you’re faced with this decision.
IRA or Roth IRA?
First the good news, you’re saving for retirement, and no matter which type of IRA you choose, your savings will get the benefit of tax free growth. This can have substantial advantages over saving in a traditional brokerage account.
In exchange for this benefit, both the traditional and Roth IRA have some very specific guideline savers need to follow. Let’s take a look at each.
Individual Retirement Arrangements, or IRAs, were created by the Employee Retirement Income Security Act of 1974, which was a landmark piece of legislation for retirement savers. Pending certain income restrictions, dollars you contribute to an IRA earn you an “above the line” deduction, which can lower your taxable income for Federal tax purposes. This perk is meant to incentivize saving for retirement.
Since the dollars going into your traditional IRA are tax free, you’ll have to pay income tax on them when you make a withdraw. If you make a withdraw sometime after age 59 ½, you will only have to pay Federal and possibly state income tax on your money, however, if you should happen to need those dollars you stashed in your IRA before age 59 ½, you’ll not only have to pay Federal income tax on them, but the IRS will also assess you a 10% penalty. There are some exceptions to this rule, but you should avoid taking dollars out of your IRA before age 59 ½ at all costs.
Senator William Roth of Delaware is the namesake of the Roth IRAs. He was a co-sponsor of the Taxpayer Relief Act of 1997 that brought this type of IRA into existence. The primary difference between the traditional and the Roth is that Roth IRAs are funded with after-tax dollars. While this eliminates the immediate benefit of a tax deduction for making a contribution, all of the dollars you withdraw from your Roth IRA after age 59 ½, both contributions and investment gains, are completely tax free. This is a game-changer if you take into account several years, even decades, of investment growth.
Just like the Traditional IRA, the IRS sets some income guidelines on Roth IRA contributions. If you find yourself exceeding these income limitations, there is a strategy referred to as a “backdoor Roth contribution,” but this is a complicated transaction and should be discussed with your advisor.
Which one is right for me?
As always, any financial advice is a highly personal and dependent on your specific situation. Generally speaking, conventional wisdom has dictated that if you’re in the early stages of your career, you’re likely to be in a lower marginal tax bracket and it might make more sense to pay that lower tax rate now and make a Roth contribution.
Likewise, if you’re mid to late career and at or near your peak earning years, you’re likely hitting a higher marginal tax bracket than you will in retirement, so a traditional IRA contribution would make more sense.
Impact of Tax Reform
Tax Cuts and Jobs Act passed at the end 2017 provided one more curveball to make a complicated decision even more confusing. This round of tax reform lowered tax brackets from their already historic lows. So, if you’re a married couple making less than $300,000 or a single filer making less than $150,000, you’re likely paying the lowest marginal income tax rate you have at any point in your lifetime. These lowered rates are also scheduled to sunset in 2026 and, without legislative intervention, will revert back to their previously slightly higher rates. Couple that with the fact that as of the most recent reading in 2018, the United States debt to GDP ratio has now spent 12 consecutive quarters above 100% after spending most of the previous decade below 65%. At some point that debt will need to be paid back, or at a minimum reduced. Since individual income taxes are the Federal government’s largest source of revenue, one can only postulate that future decades may bring a higher tax regime. Given that, Roth contributions and even conversions might make sense in this historically unique period of time.
So what makes sense for you? As I said before, financial advice is a highly personal subject, and what makes sense for you now might not be the same next year. The most important decision you can make is the decision to save for retirement. What you do after that, whether you choose a Roth IRA or traditional, you can’t go wrong.
Judson Meinhart, CFP®
Financial Planning Strategist