Roth IRA vs Traditional IRA in Retirement
Retirement is a stage in our lives that many look forward to, finally being able to enjoy the day without thinking about our employers or work schedules. To make the most of our finances in retirement it requires preparation throughout our working lives.
An individual retirement account (IRA) is one of the most popular account types in the US available for individuals to contribute towards and possibly receive tax advantages. There are a few different types and your choice of which to use can change your taxable income and the amount you can take home when you retire.
Here we will discuss the Roth IRA and how it differs from a Traditional IRA. Making informed choices around your retirement may allow you to maximize your funds in retirement.
Similarities between a Traditional and Roth IRA
The Traditional and Roth IRAs are both considered retirement savings accounts which can grow tax-deferred which means you don’t pay tax on capital gains or income while the funds are invested.
Both types of IRAs are limited in the types of contributions you are allowed to make. You are only allowed to contribute money earned by working, as opposed to inheritance, dividends, or money acquired through other means such as property. There are some spousal exceptions which we will cover in another blog post.
Differences between a Traditional and Roth IRA
The main difference between the two is the taxation of the contributions. Funds going to a Traditional IRA are taxed at the time they are withdrawn, whereas Roth IRA contributions are after-tax dollars and taxed at the time they are put in. You may begin withdrawing from either account at 59.5 years old without penalty.
Plus, unlike a traditional IRA, there are no required minimum distributions with a Roth. This means that you are not required to withdraw a minimum amount each year, which could offer a more flexible approach for some retirees.
In opposition, beginning at age 72, you are required to withdraw a percentage of the value of the IRA account (Required minimum distribution or RMD). This is done so that people are forced to pay some amount of tax on the assets that have been tax-deferred for many years.
The best option for your situation would likely depend on your current tax bracket alongside your expected tax bracket upon retirement.
There are salary rules around the Roth IRA which limit who can contribute and the amount of contributions made. In 2020, the maximum contribution amount is $6,000 for those below 50 years of age, and $7,000 for those above 50 years old. The earning limit to contribute to a Roth IRA currently sits at $124,000, so if you earn above this figure, you are likely ineligible for contributions.
If your salary is too high to open a Roth IRA, there are other options available that may be better suited to your financial situation. Please get in touch with me today to discuss your retirement.
Financial Calculations: Tax Now or Delay?
It can be a difficult decision to choose between a Roth IRA and a Traditional IRA. The overall verdict is that those wanting an immediate tax-break might prefer a traditional IRA, whereas those who would prefer a tax-break during retirement might prefer the Roth. However, it could be slightly more complicated.
For example, if you are young and at the beginning of your career, a Roth IRA might be the best choice since you don’t know what taxes may look like when you retire. You know what they are today and assume they will be higher in the years to come.
Alternatively, those who are contributing to retirement accounts and who foresee steady income and equal or lower tax bracket in retirement might opt for the traditional IRA.
Withdrawing Your Money
You can begin taking withdrawals from either account type at 59.5 without the 10% penalty. Roth withdrawals are not taxed and the Traditional IRA is taxed based on your overall income and tax bracket.
Withdrawal Exceptions
Sometimes, withdrawing money that you have put aside is unavoidable. Luckily, there are some stipulated exceptions to the 10% penalty.
Roth IRA
At any age, Roth accounts allow for withdrawals of the amounts you contributed tax and penalty-free. The earnings on a Roth are subject to taxes and penalties if you are under 59.5 and have not held the account for five years (The Five Year Rule).
If you’re under the age of 59.5 and have owned the Roth IRA for 5+ years, you will owe taxes but the 10% penalty is waived for the withdrawal of your earnings if you are:
withdrawing up to $10,000 to buy your first home
withdrawing due to disability
using the funds for qualified education expenses
paying for health insurance or medical expenses if you are unemployed
If you are over 59.5 and have not held the account for five years you may withdraw your earnings both penalty and tax-free if you meet one of the criteria above.
If you are over 59.5 and it has been five years since your first contribution, you may withdraw any contributions and earnings penalty and tax-free.
These are just a handful of exceptions and each may apply to your situation. It is important to track the history of your first Roth contribution date as well as keep good records on why you are making withdrawals if under 59.5 and have held the account for less than five years.
There are many considerations to make before committing to an individual retirement account and it is important to remember that the information discussed in this article is around the account types and taxes, not investments. Determining the level of taxation risk that you are comfortable with while working and in retirement can help determine what accounts fit into your plan. Should you wish to open a Roth or Traditional IRA, let’s talk today!