Roth IRA Vs. Traditional IRA

Employer-sponsored retirement plans are responsible for a huge chunk of America’s retirement savings. They usually come in the form of 401(k)s.

401(k)s alone aren’t enough to save for retirement. They have rules to follow, contribution limits, and limited investment choice. And as any investor worth their salt will tell you, putting all your eggs in one basket is a recipe for failure.

So where else should you look?

Well, there are a lot of other retirement accounts out there for all manner of financial situations and general life circumstances.

IRAs are one of the most common. They could be an excellent tool in your retirement savings arsenal.

There’s more to IRAs than meets the eye, though, so keep reading to learn more about the types of IRAs and their benefits to your retirement savings.

What’s An IRA?

IRA stands for Individual Retirement Account. They come in 2 main forms, each with their respective advantages and disadvantages that we’ll get into later:

Traditional IRAs
Roth IRAs

There are many other types of IRAs:

SEP
Self-directed
Non-deductible
SIMPLE
Spousal

However, we won’t be covering these as they’re far less common and more complicated.

How Does An IRA Work?

IRAs are simple. They are retirement accounts with tax advantages, meaning you get to keep more of your money IF you put it towards your own retirement.

Your money is invested into investment vehicles of your choice and then it grows throughout your career. IRAs let you pick pretty much any investment (barring a few investment types), making them excellent supplementary retirement accounts if you’re dissatisfied with your employer’s plan.

Once you retire, you can start withdrawing your funds. A withdrawal is usually referred to as a “distribution”.

In 2019, you’re limited to $6,000 of contributions per year if you’re under 50 years of age and $7,000 of contributions per year if you’re over 50. These amounts are a combined total for all your IRAs, NOT per IRA. Yes, that unfortunately means you can’t keep opening IRA accounts and stuffing them with more money.

If you withdraw your money early (before 59.5 years old), you could be subject to a 10% penalty on your withdrawal for both types of IRAs.

Where Do You Set Up An IRA?

401(k)s are easy to set up. Your employer provides you plenty of information and a way to sign up.

But what about IRAs? There’s no employer to do it for you.

Well, you have a few options:

Roboadvisors – These are excellent for more hands-off investors. They tend to offer features like automatic rebalancing and portfolio allocation, meaning you don’t have to constantly monitor and adjust your portfolio weights. Oh, and their fees are low. Some of them even provide access to human financial advisors.
Brokers – If you’re a hands-on investor, brokers are a better choice. Try to find one with minimal fees and commissions so you don’t waste a ton of money investing. If you’re new to investing, you might want to find one that provide educational resources as well. It never hurts to understand exactly what’s happening to your money. Online brokers are especially convenient as you don’t have to meet in person and you can buy and sell investments in your IRA whenever you want.

Opening your account is easy once you pick a broker. Generally, you head over to your broker/advisor’s site, select your IRA type, fill in your personal details, then decide on how to fund it.

Funding can be done one of the following ways:

Bank transfer
Brokerage transfer
401(k) rollover – Involves contacting your old employer’s plan admin, filling out some paperwork, receiving a check for you 401(k) balance, and depositing it into IRA. Brokers have rollover specialists on staff to help with this.

The Matchup: Traditional Vs. Roth

Tax Advantages

Traditional and Roth IRAs each have many characteristics that complement characteristics in the opposite account type. If that wasn’t clear, you’ll understand completely after looking at the tax advantages of each account.

Traditional IRA contributions are pretax, meaning any earnings you direct towards your IRA will not be included in your taxable income. You can enjoy tax-free growth on your investment throughout your career. However, in retirement, you’re taxed at ordinary income rates on distributions from your traditional IRA.

Roth IRAs are the opposite. You can only contribute after you’ve paid taxes on the income, but you enjoy tax-free distributions in retirement.

Neither one of these is necessarily better than the other because tax rates, IRS tax brackets, and your own tax bracket might change by the time you retire and can start taking distributions.

For example, if taxes drastically increase when you retire, then Roth would be superior as you’d enjoy tax-free money in a high-tax environment.

But many retirees find themselves in a lower tax bracket when they leave the workforce, which would make the traditional IRA the better choice.

Since we can’t see the future, you can’t really say whether traditional or Roth is more advantageous. A financial advisor could be of huge help here.

Income Requirements/Limits

Your income affects your allowable tax deduction on traditional IRAs and your allowable contributions on Roth IRAs.

When your modified adjusted gross income (MAGI) reaches a certain point depending on filing status, these benefits begin phasing out, or in other words, shrinking.

Here’s 2019’s traditional IRA deduction phaseouts:

Married Filing Jointly while you’re covered by an employer-sponsored retirement plan:

MAGI of $103,000 or less: full deduction
MAGI between $103,000 and $123,000: partial deduction
MAGI greater than or equal to $123,000: no deduction

Married Filing Jointly when your spouse is covered by an employer-sponsored retirement plan:

MAGI of $1933,000 or less: full deduction
MAGI between $193,000 and $203,000: partial deduction
MAGI greater than or equal to $203,000: no deduction

Single or Head of Household and you’re covered by an employer-sponsored retirement plan:

MAGI of $64,000 or less: full deduction
MAGI between $64,000 and $74,000: partial deduction
MAGI greater than or equal to $74,000: no deduction

Married Filing Separately and you or your spouse is covered by an employer-sponsored retirement plan:

MAGI of $103,000 or less: No deduction available
MAGI of less that $10,000: partial deduction
MAGI greater than or equal to $10,000: no deduction

As for the Roth contribution phaseouts, they couldn’t phase out a deduction since contributions are tax-free. They phase out the amount you can contribute instead.

Married Filing Jointly or Qualifying Widow(er):

MAGI between $193,000 and $202,999: reduced contribution
MAGI greater than or equal to $203,000: not eligible

Single, Head of Household, or Married Filing Separately (if you didn’t live with your spouse during the year:

MAGI between $122,000 and $136,999: reduced contribution
MAGI greater than or equal to $123,000: not eligibile

Married Filing Separately if you DID live with your spouse during the year:

MAGI less thant $10,000: reduced contribution
MAGI greater than or equal to $10,000: not eligible

There’s no clear winner in the phaseout arena. There’re simply too many numerical and filing status differences between the types of IRAs.

Required Minimum Distributions

Traditional IRAs require you to start taking contributions April 1st of the year after the year you turned 70.5. Roth IRAs never require you to withdraw anything.

Why are you forced to take distributions from traditional IRAs?

Remember, your contribution was pretax. Uncle Sam wants his share either now or later, and since you opted for later, you’re forced to pay up.

Roth IRAs win this one, only because you were already taxed.

The Verdict

The truth is that neither type of IRA is objectively better than the other. But that’s the whole point, otherwise everyone would be flocking to one type of IRA over the other.

The best IRA to open depends on the individual’s financial situation; that’s why each type of IRA seems to fill the gaps in the other one.

Want to know how to determine the best type of IRA for you? Or if an IRA is right for you at all?

That’s right: speak to a financial advisor. They can’t see the future and therefore can’t predict your situation in retirement (unless you’re awfully close to retirement), but they have the experience and foresight to determine the optimal account type based on your current financial situation and what it MIGHT be in the future.

So before you go opening IRAs willy-nilly, speak with a financial advisor.