You know you need to save up for retirement but choosing the exact method to save can seem daunting. Many would-be savers are often so overwhelmed by all of the different terms, conditions, and details that they often delay saving their money in the first place!

In the often confusing world of retirement planning, many savings and investment strategies exist. However, two very common retirement investment accounts for the individual are the traditional IRA (Individual Retirement Arrangement or Individual Retirement Account) and the Roth IRA.

This article is to help you make the decision of choosing between a traditional (pre-tax IRA) and a Roth IRA less intimidating. Although these savings strategies can seem confusing and foreign, they are designed to help you have a protected future and an amazing retirement!

But first, in order to determine which IRA you should invest into, you need to understand the similarities, differences, and regulations that govern how each IRA can be used as well as other important factors such tax implications and when you can have access to your money.

Just like a great chess player anticipates current and future events in order to execute a winning strategy, careful consideration of an individual’s current and possible future career and the financial picture also plays an important role in determining which IRA is best for you and your retirement goals. Good planning now will pay dividends (no pun intended) in the future!

Which is better the pre-tax traditional IRA or the after-tax Roth IRA?

Which is better the pre-tax traditional IRA or the after-tax Roth IRA?

General Steps To Deciding Which IRA To Use:

  • Understand each type of IRA, eligibility for investing, short-term and long-term tax implications, your goals, and rules for accessing your money
  • Consider your current tax bracket and if you think you will be in a higher or lower tax bracket when you retire
  • Know if you are you currently participating in a workplace retirement plan and the exact account name
  • Know your current level of income and tax-filing status (single, married and if filing joint or separate)
  • Don’t go it alone, seek professional guidance from a certified fiduciary financial advisor

After reviewing aspects of pre-tax and after-tax IRAs, eligibility requirements, contribution limits, and other topics such as tax implications, I will help you to answer the question of the day:

-Which IRA is best for me? (Spoiler alert, the answer is: ‘it depends!’)

A Brief History of The Traditional Pre-tax and Roth IRAs

IRAs became part of retirement planning efforts in 1974 when the Employee Retirement Income Security Act (ERISA) was enacted by Congress in reaction to generalized mistrust in how some employee pension plans were managed. When first enacted, only those who were not part of an employer-sponsored retirement plan could participate and contribute money to an IRA.

Several different IRAs have been enacted by the government since 1974, including the Roth IRA, which came to be in 1997, named after Delaware Senator William Roth who sought to provide alternative measures and encouragement for Americans to save.

Understanding The Terminology

In order to properly understand the investment rules and implications, and thus make appropriate investment decisions, it is important to understand the terminology that is used. This way, we can avoid confusion and overwhelm and increase your confidence when making an investment decision.

Tax-deferred Means that the tax payment is made at a later time, and not in current tax year
Tax-deductible Money that is eligible to be subtracted from your total income amount thus lowering your taxable income
Contribution Deposit of money into a particular account
Distribution A withdrawal made on an account, like when you withdraw money from an ATM.
Earned Income The IRS considers income to be ‘earned’ if you made income by being an employee or income made as a business owner. It is money you work to earn.
Unearned Income Interest made from money in savings, bonds, alimony, and dividends from stocks.
MAGI Modified Adjustable Gross Income

The Traditional IRA

The traditional IRA is a tax-deferred investment account that offers short term and long term benefits. You are contributing ‘pre-tax’ dollars that can be deducted from your income taxes if you meet eligibility criteria. This is one of the advantages of using a traditional IRA because you can lower the amount of income taxes that you pay in a particular year, and who doesn’t like that?

You also do not have to pay taxes on the earnings of the invested money as long as the money remains within the protection of the traditional IRA. However, it is important to understand that this money won’t always remain untaxed and you will have to pay taxes later when you begin to withdraw money from the account. Uncle Sam always wants his share, whether you pay those taxes yearly, or defer payment until later, like with a traditional IRA.

Just remember that with a traditional IRA, when you look at your account balance, not all of that money is yours as a portion of it will have to be paid to Uncle Sam at some point.

Who Is Eligible To Contribute To A Traditional IRA?

Individuals and their spouses (if filing jointly) who have earned income can contribute money to a traditional IRA until age 70 ½.  A traditional IRA can also be used to receive rollover funds from qualified employer-sponsored retirement plans such as 401(k), 403(b), or 457(b) governmental plans.

You may be wondering just how much money you are allowed to contribute to your traditional IRA every year. For 2019, you can contribute a maximum amount of $6,000 (if under age 50) and $7,000 (if over 50) per year to your IRA.

Why the difference in contribution amounts? The government allows for an extra $1,000 to be contributed as a way to catch-up and encourage savings for those over 50 because retirement is fast approaching!

How Do I know If I will Receive A Tax Deduction?

It is important to note that some individuals will not be able to deduct traditional IRA contributions from their taxes depending on their Modified Adjusted Gross Income (MAGI) and whether or not you and/or your spouse (if filing jointly) participate in a retirement plan at work.

The following scenarios, which can be taxing to read, will help you determine if you are eligible to receive a tax deduction for your IRA contributions:

If you are single or married, and you (and your spouse) are not participating in an employer-sponsored retirement plan, you can receive the full tax deduction regardless of MAGI.

If you are single and participating in a tax-deferred retirement plan at work (which is defined as having made any contribution to the workplace retirement plan, even if only the employer made those contributions):

  • Your eligibility of deducting traditional IRA contributions from your taxes phases out once your income exceeds $64,000 in 2019
  • You can’t deduct your traditional IRA contributions once your income exceeds $74,000 in 2019

If you are married and filing jointly and both you and your spouse are contributing to a workplace retirement plan:

  • And if your joint income exceeds $103,000, your eligibility for traditional IRA deduction is phased out
  • And if your joint income exceeds $123,000, you become ineligible for a tax deduction

If you are married and filing jointly and you do not participate in a workplace retirement plan but your spouse does:

  • You are eligible for the full tax deduction for traditional IRA contributions but you become ineligible once joint income exceeds $203,000 for 2019.

If you are married and filing separately, and you have a workplace retirement plan:

  • IRA contributions are partially deductible for a MAGI up to $10,000
  • IRA contributions are not deductible if MAGI is over $10,000

Don’t confuse contributions with deductions

Remember, a contribution is the money that you deposit into an account. As long as you are eligible to make contributions to a traditional IRA, you can make contributions up to the maximum allowed limit regardless of your eligibility to receive a tax deduction on those contributions.

When Can I Withdraw Money From A Traditional IRA?

You can begin making withdrawals (also called distributions) from your traditional IRA after you reach the age of 59 ½  and distributions will be taxed since it is considered income. The exact tax rate will depend on the tax bracket that you belong to when the withdrawal is made. The distributions from your traditional IRA once in retirement are considered unearned income and is taxed differently than income earned from working. However, the unearned income is factored into your adjusted gross income (AGI) and will be taxed at your marginal tax rate.

But beware, if you withdraw money from your traditional IRA before age 59 ½, the withdrawal will be included in your taxable income plus it may be subject to an additional 10% penalty on top of the income tax.

Another important detail about traditional IRAs concerning distributions is that once you are 70 ½ years of age, the IRS requires that you take a mandatory distribution, which is considered taxable income. It’s the government’s way of saying, “We want our tax money!” They won’t let you defer paying taxes forever. See IRS withdrawal rules here.

A Traditional IRA Is Good For You If:

  • You believe that you will be in a lower tax bracket than your current one when you retire
    • By being in a lower tax bracket, you will pay less income tax
  • You do not have access to an employer-sponsored retirement plan
  • You are seeking a possible* reduction in your yearly tax burden (*recall the criteria eligibility for tax deduction listed above)
  • You are a more conservative investor

The Roth IRA

There are major differences between a traditional IRA and a Roth IRA. In contrast to the pre-tax traditional IRA, the Roth IRA is an after-tax retirement account. In other words, the money that you contribute to your Roth account has already had the appropriate income taxes taken out. A stark contrast in comparison to money used to contribute to the traditional IRA.

Contribution amounts made to a Roth IRA are never tax-deductible from your income tax. However, once invested, the money in your Roth account grows completely tax-free and you will not be liable to pay taxes in retirement once you begin to make withdrawals. An added benefit is that, come retirement time, the balance you see in your account is all yours since you have already paid your dues to Uncle Sam.

Who Is Eligible To Contribute To A Roth IRA?

The eligibility criteria to contribute to a Roth IRA is fundamentally different than the criteria for a traditional IRA. The Roth IRA eligibility criteria are based on Modified Adjusted Gross Income (MAGI) levels. Money used to fund a Roth IRA must also be ‘earned income.’

For 2019, you are eligible:

  • To make a full Roth contribution if your MAGI is less than  $122,000 (single) or $193,000 (joint)
  • To make a partial contribution if your MAGI is between $122,000 and $137,000 (single) or $193,000 and $203,000 (joint)
  • You are not eligible to make contributions if your MAGI is over $137,000 (single) or $203,000 (joint)

If you make too much money to qualify for a Roth IRA, there is another option, known as a Backdoor Roth IRA, where an individual can contribute to a non-deductible IRA. Like most things, there are advantages and disadvantages to this option, but it is yet another way to save.

What Are the 2019 Maximum Contribution Limits For Traditional And Roth IRAs?

For 2019, you can contribute a maximum amount of $6,000 (if under age 50) and $7,000 (if over 50) per year to your IRAs. However, if you happen to have both a traditional IRA and a Roth IRA, you cannot contribute $6,000 into each account in the same year. In other words, the total contribution amount to an IRA in for the 2019 tax year is $6,000 (or $7,000 if over age 50).

When Can I Make A Withdrawal From My Roth IRA?

The Roth IRA allows for more flexible access to the money in the Roth, but like most things, a specific set of criteria must be met. Roth withdrawals are classified as qualified and non-qualified.

Qualified withdrawals include: being over age 59 ½, death or disability, and a qualified first home purchase.

In general, if you are 59 ½ years or older, you can withdraw as much money as you want, as long as the Roth IRA has been opened for at least 5 years. The money you take out is not taxable income, remember you already paid the tax on that money.

If you are under 59 ½ you can make withdrawals tax and penalty free up to the exact amount of the contributions. There is one big exception in that you cannot withdraw the earnings from the principal balance, otherwise, you will be tagged with an early withdrawal penalty of 10%.

Non-qualified withdrawals, essentially any withdrawals that do not meet the above-qualified criteria, are subject to a 10% early withdrawal penalty unless the withdrawal qualifies as an exception. Exceptions include the a qualifying first home purchase exception, college expense exception, disaster and recovery assistance, and qualified unreimbursed medical expenses.

Before making any withdrawals, make sure you understand the difference between qualified and non-qualified and the necessary criteria that must be met for any exceptions to be granted and whether or not your withdrawal will incur a penalty.  

A Roth IRA may be a good choice for you if:

  • You think you will be in a higher tax bracket in your retirement years
  • You think that the government may raise the income tax rate in the future
    • Essentially leading to increased taxes for those with tax-deferred retirement accounts
  • If you cannot deduct your contribution to a traditional IRA
  • If you think you will need to access your money before retirement, although this is generally discouraged
  • You want more control on when your money is distributed (as opposed to required minimum distributions of the traditional IRA after age 70 ½)
Which is better to invest in? The traditional IRA or the Roth IRA?

Which is better to invest in? The traditional IRA or the Roth IRA?

Can I Invest In Both A Traditional IRA And A Roth IRA?

You can invest in both types of accounts plus a workplace-sponsored retirement account. You just need to be aware of contributions limits (you can usually contribute much more money in a workplace retirement account) and how any desired tax deductions can be affected.

There is a fundamental objective in investing in order to decrease risk and protect your assets: diversification. Good investors diversify their portfolio so that they do not rely solely on only one type of investment. Since you can’t predict the future with absolute 100% accuracy and know for certain what tax bracket you will be in, whether or not the tax rates will stay the same or increase (as many see as a possibility), nor can you know what your exact income needs will be, it makes sense to also diversify your sources of income.

When you retire, you will be transitioning from depending on earned income to relying on unearned income from your investments. Since there will be unique tax treatment to each type of income, it is a great idea to have income from diversified sources like tax-deferred, after-tax, and tax-free accounts.

So, Should You Invest In A Traditional IRA Or A Roth IRA?

As you can see, the answer is: it depends! There is no single, cut-and-dry, black-and-white one-size-fits-all answer. 

The answer depends on your ability to contribute to a workplace retirement account, your income, your tax situation, and marital status, if you are eligible to make contributions, your investment style and what you believe will occur in your financial future, not to mention what your short term and long term goals are.

The more knowledge you have about how these accounts work, how your taxes may be affected, and how and when you will receive distributions can all be used to help you and your financial planner make an appropriate decision.

Take a look at the IRS comparison table for traditional and Roth IRAs here.

Unsure Of What To Do Next?

Keep making progress toward your retirement by saving and planning as much as possible. If you are still not sure which specific IRA is best for you, or think that your particular set of circumstances makes deciding which to choose, seek out expert consultation.

Remember, you are not alone. Reach out today and contact us for a consultation to see how you can best prepare for retirement and protect your financial future.