There are certain questions Financial Professionals are asked quite frequently by clients, family, friends, or just the person we struck up a conversation with at the grocery store. Most of the time the question is something like: “what is a good stock pick right now?” or “what did the market do today?
Another question that we are often asked, usually at the beginning of each year, is “should I be using a Roth IRA or a Traditional IRA for my retirement savings?”
You may have asked that question in the past. It can be confusing because there are many layers to these financial instruments.
When this question is brought up in casual conversation my initial answer is “I don’t know.” This often confuses people. They asked a financial planner, so how is it I don’t know. The reason for this response is because they should have a planning conversation and discuss their financial picture in detail before deciding about a Roth IRA vs. a Traditional IRA for their retirement savings. In this post I will give you a basis to begin this conversation with a financial planner.
Let’s begin with what these accounts are. The title of IRA is an acronym for Individual Retirement Account. These instruments offer you the ability to set funds aside in a tax favorable manner until retirement, considered to be age 59 ½ and beyond. You can allow the funds you contribute along with the gains the potential to grow in a tax advantaged manner while in the account. The real difference between Roth and Traditional IRAs is based on when you must pay the taxes on these funds.
The Traditional IRA is the older of the two options. Established in 1974, the Traditional IRA allowed for people to take more control of their retirement and save over time. Traditional IRAs allow you to contribute funds each year to the account, $6,000 under current tax code ($7000 if you are over 50), and you can then deduct that amount from your taxable income for that year. After it is contributed you can defer the taxes until you begin to withdraw the funds in retirement. Once you make the withdrawals, you pay taxes at regular income tax rates.
The simplest way to think about the Traditional IRA is you defer the taxes now and pay the taxes later in retirement.
Now, you might be thinking, what if I don’t need the tax deduction now and still want to gain tax advantages for the funds overtime? That question was answered in 1997 with the introduction of the Roth IRA to the American public.
The Roth IRA allows for contributions to be made to an IRA with no tax deduction now, so the contributions are taxable as income today and allow the contributions and gains the potential to grow tax deferred and withdrawals in retirement are tax-free. This is possible because the tax code and the fact that the IRS designed it to tax money one time. For the Traditional IRA, you elect to defer taxes now and pay later, and with the Roth IRA you are electing to pay now and not be taxed later.
With the Roth IRA you have the same contribution limit for each year as the Traditional IRA, $6,000 per year ($7000 if you are over 50). Once the funds are placed in the Roth IRA, those funds account for the contributions as if they stayed in your earned income for that year. From there the account can grow tax deferred and be used in retirement (past age 59 ½) as long as it has been open longer than 5 years. Since there are tax-free withdrawal advantages for the investor, there are limitations on how much you can earn and still contribute to the Roth IRA. For current tax laws, once you have household income over $139k as a single payer or $206k as a married taxpayer you can no longer contribute to the Roth IRA. Another advantage of the Roth is since your contributions have already been taxed, you can withdrawal the contributions any time after 5 years penalty free. The gains, however, must stay in the account until age 59 ½ to avoid penalties if taken early.
So, the way to think about the Roth IRA is; you pay taxes now to not pay taxes later and potential growth is also tax-free.
In both the Traditional and Roth IRAs, the age of 59 ½ is vital. This is the earliest age you can withdrawal without penalty unless you qualify for certain exceptions. Once you are past that age you are considered ‘retirement age’ and the 10% early withdrawal penalty against all funds in the Traditional IRA and gains in the Roth IRA is then eliminated.
There is another important age for Traditional IRAs, and this age just had a major change with the passing of the SECURE Act in 2019. Once you reach age 72, you must take a yearly Required Minimum Distribution (RMD) from your Traditional IRAs. This was set at age 70 ½ prior to the SECURE Act. This means each year there must be a certain amount withdrawn or you can incur up to a 50% tax penalty against the funds not taken. The IRS is serious about making sure taxes are paid on funds at some point, and the RMD is how they assure you pay taxes that have been deferred over time.
I have shared a lot of information about these accounts, but that only goes to show you that this is an important conversation to have with a financial planner. To find out more about our approach to retirement planning and IRAs here at Beratung Advisors, please give us a call at 412-357-2002 or contact us through our website at www.beratungadvisors.com.
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This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with your financial and tax professionals regarding your personal situation prior to making any financial related decisions. Waddell & Reed does not offer tax advice. 02/20