Is a Roth IRA or a Traditional IRA Better for Me?
For anyone who wants to build their financial future, an IRA (individual retirement account) is a great way to do this. Not only can you invest in securities that will compound over time, but you can also do so while contributing to your employer-sponsored retirement plan (like a 401(k)).
However, there’s one thing you’ll need to know before you open an account: Do you want a Traditional IRA or a Roth IRA?
Both have superior tax advantages over traditional brokerage accounts, but knowing the details between them and how they fit into your financial situation can really make one or the other more useful.
In this post, we’ll highlight the major differences between each type of IRA and help you to determine which one is the right choice for you.
Would you like to Pay Taxes Now or Later?
The fundamental difference between a Traditional IRA & a Roth IRA comes down to one word: Taxes.
More specifically, would you like to pay them now or when you retire?
Here’s a quick summary of how the taxes are different between a Roth and a traditional IRA.
- You get to defer your taxes in the year you make your contribution .
- Your contributions can then grow tax-deferred for years until one day when you’re ready to retire.
- When that day comes (after age 59-1/2), you can start making withdrawals and will begin paying taxes at that time.
- You pay your taxes now in the year that you make your contribution.
- Your contributions can then grow tax-free for years until one day when you’re ready to retire.
- When that day comes (after age 59-1/2), you can withdraw your money tax-free.
Which type of IRA is preferrable Mathematically?
n theory, whether one elects to contribute to a Traditional IRA or a Roth IRA, the result should be identical, assuming one’s financial profile remains steady over time . For instance, let’s say you’re currently earning $60,000 per year and are paying an effective tax rate of roughly 20%. We could then estimate that your tax bill for the year to be $12,000.
Now, what happens when you retire? If we assume your tax rate and income needs don’t change, then again, you’ll withdraw $60,000 from your nest egg and pay approximately $12,000 in taxes.
Of course, the reality for many people is that their finances change over time. Perhaps they need more or less income, enter into a different tax bracket, or the tax laws change altogether. That’s why it’s important to take the time to consider how your life during retirement may be different from your lifestyle now.
Advantages of the Roth IRA
The main goal of retirement planning is to make sure that you can be financially confident and have a large enough nest egg to last you for the rest of your life. Therefore, when you think about the two options, there are some definite psychological advantages of going with the Roth IRA.
Ask yourself this: When you’re retired and on a fixed income, do you really want to have to send 20% of your money to the IRS? Or would you rather do this now while you’re young, employed, and fully capable of recouping the taxes you have to pay?
The ability to produce tax-free income during retirement is an added luxury that makes a Roth IRA the more lucrative option.
Avoiding Forced Distributions in the Future
Taxes aren’t the only thing you have to worry about when you retire. Though many people don’t realize it, starting at age 72 , the IRS will actually start forcing retirees to withdraw a certain percentage of their money from their nest eggs every year.
These withdrawals are called, in IRS parlance, “Required Minimum Distributions,” or RMD’s for short. The reason Uncle Sam does this is to collect taxes on the savings that you’ve been sheltering all these years. By forcing you to take out a minimum amount each year, the Government can ensure that you’ll also finally pay them the taxes they were owed.
If you don’t meet your RMD for the year, the penalty is quite substantial. You’ll be required to pay an additional 50% fee for every dollar that you neglected to withdraw.
So how can you avoid this? Simple: By using a Roth IRA.
RMDs are generally only applied to those retirement accounts where you could get the tax benefit upfront (such as a Traditional IRA or 401(k) plan). But since you’ve already paid your taxes on a Roth IRA, the government is indifferent between your withdrawing from the IRA or not because it can’t collect taxes from you anyway.
This is a very important distinction to think about. If you’ve got a Traditional IRA and require less money than what the RMDs say you have to withdraw, then you’re going to be in a situation where you have to drain your IRA faster than probably would like to.
By contrast, if you use a Roth IRA, then this will not be a problem because you won’t be forced to take RMDs. That means you can withdraw as much or as little as you want without any repercussions.
Do You Earn Too Much to Contribute?
Another detail about IRAs is that if you make too much money in any given tax year, your ability to contribute to a particular IRA or enjoy tax benefits from the IRA might not be possible.
Here is what you need to know:
- If your tax status is “Married Filing Jointly,” then you’re only eligible to contribute up to the full amount of $6,000 as long as your modified adjusted gross income (MAGI) does not exceed $198,000.
- For MAGIs between $198,000 and $208,000, your eligibility gets reduced as you get closer to the upper limit. Once your MAGI is above $208,000, you’re no longer able to contribute to a Roth IRA at all.
- For other tax filing statuses and circumstances, you can find the complete set of IRS rules here.
- When it comes to traditional IRAs, the rules are a little bit different. You’re always eligible to contribute to one, no matter how much money you earn.
- However, there’s a catch. If your tax status is married filing jointly and you’re covered by a retirement plan at work, then you only get to defer your taxes if your MAGI is less than $105,000 (as of 2021).
- If you make more money than this, then you can still contribute to a traditional IRA, but you won’t get the upfront tax deduction for the year. You’ll only get tax-deferred earnings for as long as the money grows inside the IRA.
- For the complete set of traditional IRA deduction rules, you find out more here from the IRS.
What Does This Mean for Me?
In short, if your income is above the Traditional IRA deduction limit but below the Roth IRA income limit, then you’d be better off contributing to the Roth IRA. Without the tax deduction benefit of the Traditional IRA, there’s really not a lot of incentive to go this route.
What If You Need the Money in an Emergency?
Even though the sole purpose of your retirement savings should be to build long-lasting, sustainable income, it’s nice to know what your options are in case you’re ever in a true emergency and need the money as soon as possible.
Here’s what you can expect with each type of IRA:
- Because you haven’t paid taxes on this money yet, you will owe both taxes and a 10% penalty to the IRS for any withdrawals before age 59-1/2.
- You’re also not allowed to borrow money like you can with an employer-sponsored plan. But you can make what’s called hardship distributions under special circumstances such as medical costs, buying a home, higher education, etc.
- Since you’re already paid taxes on your contributions, you can technically take them out anytime you want without penalty. However, any money that you’ve earned on these contributions is not eligible for withdrawal before age 59-1/2 unless you pay taxes and pay a 10% penalty.
- Similar to the Traditional IRA, you can make hardship distributions under special circumstances.
- Between the two, you’ll find that the Roth IRA is the easier of the two options to work with in terms of making withdrawals before age 59-1/2. As long your withdrawal is less than the total of all the contributions you’ve made to date, then you won’t have to pay any taxes or penalties to the IRS.
Fund Your IRA with Israel ETFs
As you can see, there are many different points to consider when choosing between a Traditional IRA or Roth IRA. Even though taxes will be one of the biggest factors, you’ll also want to weigh other points like income eligibility and the withdrawal rules. Determine how each one may affect your overall financial decision before deciding which option is right for you.
No matter which type of IRA you pick, remember that retirement planning is a long-term investment in your future. To get the best returns possible, you’ll want to fund your IRA with quality securities such as diversified equity Exchange-Traded Funds (ETFs).
The Jerusalem Portfolio (TJP) is an Israeli-focused investment fund that contains many reputable ETFs and provides the investor with fractional interests in several Israeli public companies. This will help you be diversified across a broad range of industry sectors each seeking to achieve long-lasting growth and profitability.
You can easily open a TJP account by contacting us. Open your TJP IRA today!