As a financial advisor, I am often asked the question “Should I be making Roth contributions?” and “What is the difference between a Roth IRA and Traditional IRA?” Most people have heard of Roth IRAs and many of them even make contributions to Roth in an IRA or 401K without fully understanding how these accounts work.
So, what is the difference between a Roth IRA and a Traditional IRA? The primary difference between a Roth and a Traditional IRA is how and when you get a tax break. Contributions to a Traditional IRA may be tax-deductible in the year that they are made, and these contributions grow tax-deferred until you make withdrawals in retirement. Roth IRA contributions, on the other hand, are made after-tax, grow tax-free, and allow for tax-free withdrawals in retirement.
Now, if you can say for certain whether your tax rate is going to be higher or lower in the future, then you can theoretically pick the type of IRA that will give you the largest tax savings in the long run. If you expect your tax rate to be higher in retirement, then making your contributions to Roth may afford you greater tax savings. If you expect your tax rate to be lower in retirement, then making pre-tax contributions to a Traditional IRA may be the way to go. However, no one can really say for sure what your tax rate will be in retirement, particularly if retirement is decades away. Therefore, you must take other factors into consideration when deciding between Roth or Traditional IRA contributions such as income limits, eligibility for employer retirement plans, and distribution requirements.
You can make contributions to a Traditional IRA at any income level but there is a limit to the deductibility of these contributions. Whether you can deduct your Traditional IRA contributions depends on your income level, tax filing status, and eligibility for an employer retirement plan. Contributions to a Roth IRA are subject to their own income limits. There is no limit on Roth Conversions and even if you are unable to directly contribute to a Roth IRA, you can make contributions to a non-deductible IRA and convert to Roth. This strategy is often referred to as a back-door Roth contribution. If you qualify for both Traditional and Roth IRA, you can make contributions to both as long as the combined contribution is $6,000 or less ($7,000 for people 50+). Here is a summary of the contribution amounts and income limit rules:
Eligibility to Employer Plans
Your eligibility to contribute to an employer-provided retirement plan is an important consideration when deciding how to save for your retirement. Employer plans such as 401Ks and 403Bs are similar to IRAs in that you can make contributions pre-tax and they grow tax-deferred until you make withdrawals in retirement. You may also be able to make Roth 401K or 403B contributions if your employer offers that option. For 2019, employees can contribute up to $19,000 / year into a 401K ($25,000 / year for people 50+). You can contribute to both pre-tax 401K and Roth 401K as long as your total employee contribution amount does not exceed the limit.
Traditional IRAs and employer plans such as 401Ks all have Required Minimum Distributions (RMDs) in the year that you turn 70 ½. Roth IRAs do not. If you save a significant portion of your retirement money in an IRA or 401K, you may find that your RMDs in retirement exceed the amount of money you need to live on, and they are a primary driver of your tax bracket in retirement. Remember, your pre-tax contributions to IRAs and 401Ks are fully taxable as ordinary income when withdrawn. Most 401K plans also have RMDs for their Roth 401K dollars, but you can avoid these distributions if you roll over your old employer Roth 401K to a Roth IRA before age 70 ½.
Roth IRA contributions (but not earnings) can be withdrawn penalty-free and tax-free at any time, even before age 59 ½. If you are under 59 ½, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time home-buyer expenses, provided at least 5 years have passed since your initial contribution.
To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 and a half or due to death, disability, or a first time home purchase (up to a $ 10,000-lifetime maximum).
Also, there is no income limitation to contributing to a Roth 401K. Even if you are over the income limits for a Roth IRA (to be eligible for a Roth IRA, you must have a modified adjusted gross income under $135,000 to contribute for the 2018 tax year), you are still able to contribute to the Roth 401K.
Talk to your financial advisor to see if you would benefit from investing in Roth.