Traditional vs Roth IRA- A deeper dive
Updated: Jan 18, 2021
There are many different methods and vehicles you can use to help you save for retirement. Much of it boils down to your own individual agendas and goals, however, the vehicles you can achieve these goals with have stayed relatively the same. Typically, you will find the most popular include a 401K, a Roth 401K, and traditional brokerage account. Also up there in popularity include a traditional IRA account and a Roth IRA account. Throughout this article, we’ll go over the difference between both as well as how each can add a benefit depending on your current financial situation.
Roth Versus Traditional
Before diving into topics of eligibility, RMD’s and more, let us review the difference between a Traditional IRA versus a Roth IRA.
A Traditional IRA or Individual Retirement Account is a vehicle in which you can grow your hard earned money to assist in saving for retirement. With a Traditional IRA, you can be eligible to deduct your contributions at the end of the year. Also, your wealth will grow tax-deferred until you begin taking distributions, which will be taxed at your income level at the time of distribution.
A Roth IRA is another Individual Retirement Account in which you use post tax dollars to invest, however, when you withdraw your funds during retirement you will not pay taxes. Also, your wealth will be appreciating tax free in your Roth IRA account. Contribution limits, which we’ll go over in the next section, are the same as a Traditional IRA. Lastly, there are no RMD’s or Required Minimum Distributions with a Roth IRA, which there are with Traditional IRA’s.
First and foremost, let us understand the eligibility requirements for IRA’s. One of the main differences to understand is you can have an IRA, regardless if you have a 401K or not. However, you may find there could be tax consequences depending on your current financial situation.
A cause for a change in your taxation could be due to the active participant rule. This is defined as, “someone who receives benefits under an employer sponsored retirement plan or participates in a retirement plan”. Qualified plans include 401K plans, defined benefit plans, money purchase pension plan, SEP IRA, or SIMPLE IRA. Utilizing one of these plans can have an impact on your eligibility to claim a tax deduction for contributions made to a Traditional IRA.
According to RetirementDictionary.com, “you are eligible to take full deduction for your traditional IRA contribution if you are not an active participant, or married to an active participant. On the other hard, if you are an active participant or married to an active participant, your eligibility for deducting a traditional IRA contribution depends on your modified adjusted gross income and tax filing status”.
Also, you should consider the contribution limits when researching if an IRA if right for you. For 2018, if you are under 50 years of age your limit is $5,500, and if you are over the age of 50, you can contribute $6,500. However, should you make enough money, you may be ineligible to contribute to an IRA. Fidelity Investments has a chart you can view to see where you fit.
As with any investment account, there are consequences for early withdraws, along with RMD’s and other withdraw features. First we will start with a Traditional IRA.
With a Traditional IRA, the first and most important is there is a penalty for early withdraw. At the age of 59 ½, you can begin taking withdraws from a Traditional IRA without incurring a 10% additional penalty. Should you withdraw prior to 59 ½, you will be forced to pay a 10% penalty, on top of your current tax bracket. However, keep in mind that with a Traditional IRA, you are not required to take a distribution until the age of 70 ½.
Other items you may be eligible to use Traditional IRA funds without a 10% early withdraw penalty include a first time home purchase, medical expenses that are unreimbursed, or certain college expenses.
Switching to a Roth IRA, the withdraw rules a slightly different. First, there is no RMD as this money is contributed post tax. Similar to a Traditional IRA, 59 ½ is the age limit for when you can begin taking money out without having to pay taxes and penalties on the earnings. Another item to avoid is if your Roth IRA has been opened for less than 5 years, you may be subject to penalties and taxes on the earnings as well.
After the age 59 ½ and if your Roth IRA has been opened for more than 5 years, you can withdraw your funds without penalty or tax implications. The beauty with a Roth IRA is since your funds were post tax, you don’t have to worry about paying taxes on withdrawn money. However, should you need to access your money for a medical expense, first time home purchase, or college, it will follow the same guidelines as a Traditional IRA.
Should you find yourself with a Traditional IRA and are now wanting a Roth IRA, there may be the possibility of converting it into a Roth. Also known as a backdoor Roth IRA, you will have to pay income taxes on the contributions made to the Traditional IRA. When doing so, ensure it fits your financial situation because transitioning could throw you into a higher tax bracket for that tax year.
This may seem like a lot of information but once you understand it is very simple to apply. Talking to your financial advisor would be a recommended place to start. Each individual has different investment objectives and retirement goals, and each vehicle fits different needs better. IRA’s are an efficient way to save for retirement and build wealth in a tax efficient manner.