In the world of financial planning, the Roth IRA sometimes looks like the cool younger brother of the more vanilla traditional IRA. Indeed, the Roth version, first introduced in 1998, offers a number of features that look pretty attractive: a lack of required minimum distributions (RMDs), the flexibility to withdraw money prior to retirement and the ability to make contributions past the age of 70½.
At first glance, the choice between the two individual retirement accounts looks like a pretty easy one. But dig a little deeper, and you’ll notice that the traditional version of the IRA has some allure of its own. Often choosing between one or the other comes down to how much you’re making now and how much you expect to bring in once you stop working.
Before going any further, here’s a little refresher on the respective IRAs. Both types offer distinct tax advantages for those squirreling away money for retirement – but they work a little differently.
With a traditional IRA, you invest pre-tax dollars and pay income tax when you take money out in retirement, paying tax on both the original investments and what they earned. A Roth is just the opposite. You invest money that’s already been taxed at the ordinary rate and withdraw it – and its earnings – tax-free at a later date.
In choosing one over the other, the key issue is whether your income tax rate will be greater or lesser when you start tapping your funds. Without the benefit of a crystal ball, that’s impossible to know for sure. For instance, Congress could make changes to the tax code during the intervening years.
The other difference between the accounts, which seems very far off to most IRA investors, are the RMDs mandated by traditional IRAs. These are cash withdrawals from the account (on which you pay taxes) that must start the year following the year in which its owner turns 70½. Roths have no RMDs.
That said, you’re forced to make an educated guess if you open up an IRA. For younger workers who have yet to realize their earning potential, Roth accounts have a definite edge. That’s because, when you first enter the workforce, it’s quite possible that your effective tax rate will be in the low single digits. Your salary will likely increase over the years, resulting in greater income – and quite possibly a higher tax bracket – in retirement. Consequently, there’s an incentive to front-load your tax burden. (If your employer offers a Roth version of the 401(k), the same logic applies to those accounts.)
“We advise younger workers to go with the Roth because time is on their side,” says financial advisor Brock Williamson, CFP, with Promontory Financial Planning in Farmington, Utah. “Growth and compounding is one of the beautiful truths about investing, especially when the growth and compounding is tax-free in the Roth.”
When Not To Open A Roth IRA
When to Forgo the Roth
But the opposite might be true if you happen to be in your peak earning years. If you’re in one of the higher tax brackets now, it may have nowhere to go but down in retirement. In this case, you’re probably better off postponing the tax hit by contributing to a traditional retirement account.
For the most affluent investors, the decision may be a moot point because of IRS income restrictions for Roth accounts. In 2018, individuals can't contribute to a Roth if they earn $135,000 or more per year – or $199,000 or more if they’re married and file a joint return. (For 2019, those figures rise to $137,000 and $203,000.) While there are a few strategies to legally circumvent this rule, those with a higher tax rate may not have a compelling reason to do so.
Of course, if you’re somewhere in the middle of your career, predicting your future tax status might seem like a complete shot in the dark. In that case, you can contribute to both a traditional IRA and a Roth IRA in the same year, thereby hedging your bet. The main stipulation is that your combined contribution can’t exceed $5,500 annually ($6,000 for 2019), or $6,500 ($7,000 for 2019) if you’re age 50 or over.
There can be other advantages to owning both a traditional and a Roth IRA, says James B. Twining, CFP, founder of Financial Plan, Inc., in Bellingham, Wash. “In retirement, there may be some ‘low tax’ years due to large long-term care expenses or other factors. Withdrawals can be taken from the traditional IRA in those years at a very low or even a 0% tax bracket. There may also be some ‘high tax’ years, due to large capital gains or other issues. In those years, the distributions can come from the Roth IRA to prevent ‘bracket spiking,’ which can occur with large traditional IRA withdrawals if the total taxable income causes the investor to enter a higher graduated tax bracket.”
The Bottom Line
Sure, there are a lot of unique benefits that go along with a Roth IRA. But beware of any one-size-fits-all approach to retirement planning. If you’re in one of the top tax brackets already, a traditional IRA might provide an even bigger boost to your nest egg.