By ROB WILLIAMS
MARCH 01, 2018
Both traditional and Roth IRAs can be effective retirement savings tools, but eligibility limitations mean one or both may not be right for you. Here’s a guide to help you choose.
What’s the difference between a traditional and Roth IRA?
A traditional IRA is an individual retirement account that allows you to make contributions on a pre-tax basis (if your income is below a certain level) and pay no taxes until you withdraw the money.¹ This makes traditional IRAs an attractive option for investors who expect to be in a lower tax bracket during retirement than they are now.
On the other hand, Roth IRA contributions are made with after-tax dollars. The benefit of a Roth IRA is that you can withdraw your contributions and earnings tax-free after 59½, if you’ve had the account for at least five years, or you meet certain other conditions.² In addition, your after-tax contributions to the Roth account can be withdrawn at any time, tax and penalty-free (however, if you make an early withdrawal of any earnings you will have to pay taxes and penalties on them).
This makes a Roth an attractive option for investors who expect to be in a higher tax bracket during retirement than they are now. A Roth IRA can also offer some spending flexibility in retirement, as money can be withdrawn without increasing your tax bill and you won’t have to take annual required minimum distributions (RMDs) after you turn 70½.
How much can I contribute?
For the 2017 and 2018 tax years, the maximum amount you can contribute to a traditional or Roth IRA is $5,500 ($6,500 if you’re age 50 or older). However, there are some rules that affect IRA contributions and deductibility. Here’s an overview:
There is no income limit for contributing to a traditional IRA, and the contribution is fully deductible if neither you nor your spouse was covered by a retirement plan at work during the tax year. However, if either of you was covered by a workplace retirement plan, deductibility phases out depending on your filing status and income:
Source: Internal Revenue Service
Roth IRA contributions are made with after-tax dollars. You can contribute to a Roth IRA only if your income meets certain limits:
Source: Internal Revenue Service
So if you do qualify for a traditional IRA (with the ability to deduct contributions) and a Roth IRA, how do you choose between them? Here are thoughts and guidelines 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 has yet to reach your peak earning years.
Roth and traditional IRA, now and in retirement
Note: Calculations assume a $5,000 starting pretax contribution in the deductible IRA and a $3,750 post-tax contribution, at a 25% tax rate, in the Roth IRA. The hypothetical examples assume a 6.5% average annual return over 25 years. The traditional deductible IRA taxes at withdrawal are a based on a 30%, 25%, and 20% marginal income tax rate.
- If you think your tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. 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 RMDs with a Roth, and if you leave it behind when you die, your heirs can stretch out their own tax-free withdrawals. A Roth IRA can also be a flexible source of retirement funding: You can withdraw a large sum, if you have a large one-time expense or other needs in retirement, without increasing your tax bill. Allocating a portion of your retirement savings to a Roth can increase the flexibility you have to manage taxes in retirement.
Another advantage of a Roth IRA is that contributions may be withdrawn any time 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 2018, 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. Also, remember that you have other options, including keeping your assets in your former employer’s plan, rolling over assets to your new employer’s plan, or taking a cash distribution (on which taxes and possible withdrawal penalties may apply).
An increasing number of employers are offering Roth 401(k) options in addition to traditional 401(k)s. With a Roth 401(k), you can contribute a portion or all of your paycheck up to certain limits. You can also choose to have some of your paycheck go pre-tax into a traditional 401(k) and some post-tax into a Roth 401(k). Any employer match or contribution, however, must go into a traditional 401(k).
Unlike Roth IRAs, Roth 401(k) contributions are not subject to earnings limits. This means that if you aren’t eligible to contribute to a Roth IRA because your income is too high, you may be able to contribute to a Roth 401(k). Distributions from a Roth 401(k) are subject to the same general tax rules as a Roth IRA, with exception of an RMD requirement starting at age 70 ½. You can avoid this by rolling over a Roth 401(k) balance into a Roth IRA. So if you’re eligible, don’t forget the Roth 401(k) option if a Roth makes sense to you.
Roth IRA conversions
If you’re ineligible for a Roth IRA, some investors maximize 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 (sometimes called a “backdoor Roth conversion”). The process is similar to any other Roth conversion, but typically takes place very soon after contributing funds to a traditional IRA. There is some debate among tax professionals about whether doing this conversion immediately or repeatedly could be outside Congressional intent when they changed the Roth conversion law in 2010.
The IRS has not formally weighed in on this topic, so be aware that there may be some risks to this strategy. If the IRS decides to question the conversion, you may owe a 6% tax or other taxes for overfunding your Roth. For some investors, this type of Roth conversion could be a viable way to obtain the benefits of tax-free growth, so long as they’re comfortable with the potential uncertainty, and work with a certified public accountant (CPA) or tax professional. If your employer offers it, you might also choose to make a contribution to a Roth 401(k). These have no earnings limits and have higher contribution limits.
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.
¹ If you withdraw money from a traditional IRA before age 59½, your deductible contributions and earnings (including dividends, interest, and capital gains) will be taxed as ordinary income. You may also be subject to a 10% penalty on early withdrawals, and a state tax penalty may also apply. Consult IRS rules before contributing to or withdrawing money from a traditional IRA.
² If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in certain situations. If you’re older than 59½ but haven’t met the five-year holding requirement, your earnings may be subject to taxes but not penalties. If you’re under age 59½ and your Roth IRA has been open five years or more, you may be able to avoid taxes on the earnings in certain situations. Consult IRS rules before contributing to or withdrawing money from a Roth IRA.
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A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer’s plan; rolling over assets to a new employer’s plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.
When a participant rolls a Roth 401(k) balance to a new Roth IRA, the five‐year qualification period starts over. This may impact the rollover decision. If the participant has an established Roth IRA, then the qualification period is calculated from the initial deposit into the IRA and the rollover will be eligible for tax‐free withdrawals when that five‐year period has ended (and the age qualifier has been met).
Each Roth conversion has a separate five-year holding period for determining withdrawal penalties.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.