Traditional vs. Roth IRA's

I’m one of those people that tends to over analyze things. Hey, we all have flaws, right? For instance, when a burger recipe calls for ground beef, my head starts spinning with questions about which beef I should buy. Should I get regular, organic, grass-fed? What fat percentage would be best? Or should I stay local and go get it from the meat market? I rarely make the same decision, yet I am usually happy with my meal once I eat it! It’s probably because the most important aspect isn’t the type of beef, it is that I was making a homemade burger.

This is the type of dilemma that many people go through when they are trying to decide whether to contribute to a Roth or Traditional IRA. Let me cover a few characteristics to explain the key differences between these accounts. 

Current Year Deduction – Traditional: Yes            Roth: No

A traditional IRA usually allows you to take a tax deduction in the current year. A Roth IRA does not. Let’s assume you make a $5,000 contribution and are in the 22% tax bracket. A traditional account would give you a tax deduction of $1,100 in the current tax year.

Tax Deferred Growth – Traditional: Yes                 Roth: Yes

Both accounts will allow the money to grow tax-deferred. This means that if your $5,000 grows to $10,000, you don’t pay tax on that growth. Similarly, you do not pay tax on any dividends or interest paid by the investments in the account if it stays within the IRA.

Withdrawals before Retirement – Traditional: No            Roth: Maybe

I generally don’t like withdrawing from any retirement account before retirement, but in a true emergency, a Roth has more options. Roth contributions can be taken out tax-free at any time. That $5,000 you put in can be taken out two years from now if needed. Traditional IRA withdrawals will be taxed at ordinary rates and a 10% penalty. There are some instances where you can withdraw the Roth earnings without tax consequences, such as a first-time home purchase, but I usually try to avoid withdrawing before retirement unless you are out of other options.

Withdrawals after Retirement (Age 59.5) – Traditional: Taxable Roth: Tax-free

Here is where the fun starts. This debate would be pointless if everyone could fast-forward to retirement and know what tax bracket they are in and how much is in their accounts. Unfortunately, Elon Musk hasn’t invented time-travel, so we are stuck estimating. Traditional accounts are taxed as ordinary income when the withdrawals occur. Taking out $10,000 from your traditional IRA would result in an additional $10,000 of income on your tax return in that year. Roth accounts are not taxed. You could take out $1,000,000 at one time during retirement and it would not cost you anything in taxes.

Required Minimum Distributions (RMDs)– Traditional: Yes          Roth: No

When you reach age 70.5, traditional retirement accounts require you to withdraw a certain amount each year. This was established to prevent people from holding their money in a tax-sheltered account. Roth accounts do not have any RMD’s during your life. You can hoard it all until you die!

Transfer upon Death – Traditional: Taxed to beneficiaries              Roth: Tax-free

Upon death, both accounts can be passed on to beneficiaries. Traditional accounts will be included in ordinary income when the beneficiary withdraws money. Roth accounts will no be taxed. However, both accounts will require the beneficiary to set up required minimum distributions.

As always, there are exceptions and various circumstances to consider for almost all these rules, but I won’t go into that detail today. Make sure to check with your CPA to see if you are eligible to make contributions to either type of account.

Simple, right? Here’s the thing… I could run 20 scenarios for you to determine which account is the most beneficial, but I could still be wrong. The tax laws can and will change. The general rule is that if you are younger, a Roth is more beneficial. If you are in a higher tax bracket, a traditional is more beneficial. You may also have these choices in your 401(k) which can further complicate your decision making. The important thing is that you are contributing towards retirement! Any retirement contribution is a great decision.

If you’re still in doubt, go with the Roth. I find a sense of relief knowing that the money in your Roth accounts is all yours and will never be taxed again.

Don’t forget you can make IRA contributions for the 2018 tax year until April 15, 2019!

- Mike Zeiter, CPA/PFS