Traditional IRA versus Roth IRA: Which is a Better Option?

By Asha Inamdar, CPA

Tax-free! Of course, that’s what everyone likes to aim for. As we all know, IRAs provide an easy way to accumulate tax-free money and save for retirement. With recent changes in US tax laws however, Roth IRAs may be a better way to save than traditional IRAs.

US tax laws went through a major overhaul in December 2017 with The Tax Cuts & Jobs Act (TCJA). Marginal tax rates with the TCJA may be the lowest we will see in recent times, but they could soar again around 2026. There is no better time than the present to channel your investments into the right tax-free vehicle and maximize your post-retirement wealth.

Taxes with a Roth IRA versus a Traditional IRA

 

Roth IRA

Traditional IRA

What happens to money you contribute each year?

Taxed at current rates

Tax-free

How is withdrawn money taxed?

Tax-free

Taxed at current rates

The biggest difference between traditional IRAs and Roth IRAs is when your savings are taxed. The money you add to your traditional IRA each year is not taxed. With either a Roth IRA or Designated 401(k) Roth, these contributions are taxed at current rates. This used to make traditional IRAs an appealing option.

But with a possible tax hike on the horizon, the important difference between traditional and Roth IRAs is how you are taxed when you withdraw funds. You are taxed at current rates when you withdraw money from a traditional IRA. But with a Roth IRA you can withdraw funds penalty-free and tax-free, once you meet the following conditions:

  • Aged at least 59 ½ years
  • Holding the account for at least five years

Given the possible tax increase in 2026, it may be wise to choose a Roth IRA. That way, you can be taxed now when you contribute funds, and avoid paying taxes on withdrawals later when tax rates will likely be higher.

There are a few other reasons a Roth IRA may work better for you.

Minimum Withdrawals from your Traditional IRA Each Year

Around age 70 or older, Required Minimum Distributions (RMDs) begin. RMDs are the minimum amount of money that retirees must withdraw from their traditional IRA each year. All withdrawn money can be taxable for most people on a traditional IRA, even if they only take out the RMD each year.

When your RMDs are taxable, it can create a domino effect for your income and savings:

  • Higher marginal tax each year
  • Social security income becomes taxable
  • Medicare Part B premiums rise in cost

RMDs on a traditional IRA can trigger a huge blow to the retirement pay that most people would take home.

These days, more people are retiring in their late 50s or early 60s. Since RMDs don’t begin until 70 plus years, early retirees can find ample tax planning opportunities.

Converting from a Traditional IRA to a Roth IRA

If you have been contributing to a traditional IRA for many years, you can still take advantage of current tax savings. For example, if you are between the ages of 60-70, you could convert part of a traditional IRA to a Roth IRA and pay just 10-12% marginal tax rates on your withdrawal.

If you stayed with the traditional IRA, you could end up paying around 22% or 24% in taxes on your RMDs at age 70 ½. Withdrawals could even get taxed as high as 25% or 28% by 2026.

By converting your traditional IRA to a Roth IRA now, your withdrawal would be taxed at barely 12 cents per dollar at today’s rates, compared to 24 cents per dollar later. That’s a 50 percent savings! Simply put, you can retire with greater wealth if you take advantage of lower tax rates now.

Better still, there are no income restrictions to convert from traditional IRA to Roth IRA. That’s precisely why employees are offered this option at all salary levels by some employers.

How Much Can I Contribute to a Roth IRA?

For 2018, if you are under 50, you may contribute up to $5,500 into a Roth IRA. Those over 50 can contribute up to $6,500. You can also contribute to a Roth IRA on behalf of a non-working spouse from your earned income.

These limits are subject to an income threshold of $189,000 for married filing jointly and $120,000 for single filers. People earning higher incomes may contribute a lower amount.

Saving Money with a Roth IRA

No matter your age, people with employer-sponsored Roth IRA retirement plans should definitely consider this option. With previous tax rates, traditional IRA options would have seemed a better bet. But with the new tax rates in play, Roth contributions may be the shining knight in armor. After all, a penny saved is a penny earned!

Every tax situation is different. Speak with an experienced tax professional today to maximize your retirement savings.