Choosing the right IRA type – Traditional vs Roth – for an individual is an integral part of career strategy and future investment plan.
What is IRA?
In order to meet the needs of an individual post his career, Individual Retirement Accounts (IRA) are designed as tax advantage vehicles which support in long term savings and investments.
While it is important for any individual to have a savings plan in hand as a umbrella for the future rains, it is important to understand that IRA is not an investment it is like a basket wherein you keep stocks, bonds, mutual funds and other assets.
Besides the Traditional and Roth IRAs there are other types like – Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. Each IRA has its own set of rules with eligibility restrictions based on income and employment status, contribution limits, penalties and many others.
Types Of IRA
Besides IRA being available at workplace, there are two basic types – Traditional IRA established in 1974 and Roth IRA launched in 1997 named on its sponsor, Sen. William Roth. While the main goal of both remain same, let’s understand the differences between the two from the tabular format below:
|Traditional IRA||Roth IRA|
|Contributions deducted now, taxes on withdrawals paid later||Taxes on contributions paid now and avail tax-free withdrawals later|
|It has age limit of anyone younger than 70½ is eligible to contribute||No age limit, but income eligibility restrictions|
|Required minimum distributions mandatory with taxable withdrawals of a % of funds||No required minimum distributions, they are like wealth transfer vehicles|
|Withdrawal before retirement age requires you to pay taxes and early withdrawal penalty||Withdrawal of sums equivalent to Roth IRA contributions penalty- and tax-free at any time|
Detailed Discussion On Which Type To Choose
The most difficult situation when you ought to choose the best from two benefits available. In this case, if you could answer the question as to which IRA would generate the maximum tax savings then you have made the better decision of your life.
Roth IRA can be chosen if expected tax rate is higher in retirement with delayed tax benefits while traditional IRA is for lower tax rates in retirement and upfront tax advantage.
However, with difficulties in deciding how much the tax rate would be at your retirement age, there are many other factors that can help you ease with your decision. The IRS rules to contribute to any of the IRAs also have to be checked .
Also, it is important to keep in mind that contribution to a traditional and Roth IRA is also possible simultaneously in the same year provided the total amount does not exceed the maximum allowable contribution limit.
In both 2020 and 2019, the most an individual is allowed to contribute per year is $6,000, or $7,000 if you’re age 50 or older. compared to $5,500 and $6,500 in 2018.
Roth IRA Preferred
A few reasons to note why Roth is recommended over traditional are –
- Early withdrawal rules are much more flexible with a Roth
- The Roth has fewer restrictions for retirees
- Unless you’re an extremely disciplined saver, you’ll end up with more after-tax money in a Roth IRA
- Funding a Roth in conjunction with your 401(k) provides tax diversification
However, upfront tax break serves as the bull’s eye point to choose traditional IRA as it is a major benefit for high earners and a great incentive for people who might otherwise skip saving for retirement. Also, in the short run it effectively makes it cheaper to save for retirement, since the tax savings each year reduces the cost of your contributions.
Best IRA To Choose In Current Scenario
With stock market being in the red and required minimum distributions waived off in 2020, it seems like an ideal time to convert retirement savings from traditional IRA to a Roth IRA. As discussed, Roth IRA withdrawals are tax free in retirement and those taxes are more affordable in current times with DJIA down 14% in the first four months of 2020.
For the current year, CARES Act allows retirees with other sources of income the added bonus of skipping a year with required minimum distribution. The waiver applies to RMDs from all traditional individual retirement accounts, including inherited IRAs, as well as defined contribution plans such as 401(k)s. This can reduce tax bill by 30% to 40%.