How to Choose Between a Traditional and Roth IRA
How are your prognostication skills? Do you have a direct connection to the spiritual world or an uncanny ability to predict the future? Someone with these skills and an individualistic drive, and perhaps an advance edition of Gray’s Sports Alamanac, could ensure the financial stability of his or her future.
The rest of us without supernatural powers and without help from a time-traveling friend can only make financial decisions affecting the future on assumptions and best guesses. When it comes to choosing between the two flavors of IRAs, Traditional or Roth, that’s the best we can do.
Looking at my balance sheet, I’ve had IRAs all over the place. I didn’t start one until I was 26 years old, and I wish I had started earlier. Motivational speakers say that you can find a way to invest regardless of your income, even if it’s just a tiny portion. Out of college, I wouldn’t have ignored such advice as my initial salary at a non-profit did not even pay for my commute to work. (I could have moved closer to work, which I eventually did, but then rent costs would have hurt me just as bad; I could have shared a house with a multitude of roommates I didn’t know, but I drew the line there. There’s always an excuse to make, but there’s also a line.)
Since then, I’ve chosen mostly Roth IRAs, though I’ve ended up with Traditional IRAs after changing jobs from each employer to the next. And while I worked on my own, I invested in Traditional IRAs.
The IRA (Individual Retirement Agreement or Account) would be one of the fundamental retirement vehicles available in the United States. It is designed to encourage people to think about the future by providing tax incentives for investing or saving. Social Security, a system designed to assist an aging society, can’t on its own keep those who are too old to work out of poverty. The IRA encourages some personal responsibility.
An IRA can contain just about any type of investment. You can use it for risk-free savings, particularly in the form of certificates of deposit, or you can invest in individual stocks, ETFs, and mutual funds. You can even find opportunities to use your IRA to invest in hard assets like real estate and precious metals.
Traditional IRAs offer savers and investors a tax deduction today, with Roth IRAs push that tax advantage until retirement, when you can withdraw your principal and earnings tax-free. The first question in this decision does not require future assumptions.
Is your income under the tax-deductibility limit? This year, your ability to take advantage of the tax deduction begins to phase out once your modified adjusted gross income reaches $58,000 ($90,000 if you’re married) and completely disappears at a level of $68,000 ($110,000 if you’re married). If your income is above these limits, you can contribute to a Traditional IRA, but you won’t receive the full tax deduction.
Are you allowed to contribute to a Roth IRA? There is another income limitation. Roth IRAs are only available to people earning under a specific amount. Single filers can contribute the full $5,000 to a Roth IRA if their income is below $110,000 ($173,000 for married filing jointly). The maximum investment phases out until income reaches $125,000 ($183,000 for married filing jointly).
Will your tax rate be higher when you’re in retirement? Ever since the regulation that allowed for Roth IRAs was enacted, financial professionals began encouraging young workers to enroll. At the start of a career, a young employee could likely be at the lowest income level of his or her life. They could also be in the lowest tax bracket they’ll ever see. A tax deduction on $6,000 of income in the lowest tax bracket is not as worthwhile as a deduction on $5,000 of income in the highest tax bracket. If you expect your tax rate to increase, pay tax on the $5,000 directed to your Roth IRA today in order to withdraw your principal and earnings tax free when you retire.
There are many assumptions built in to the above reasoning as well as variables that might change. Congress may decide to change the rules for Roth IRAs, making withdrawals in retirement taxable. That could defeat the purpose of forgoing the Traditional IRA deduction today. If you presume you won’t be in a higher tax bracket in retirement, you may be wrong, as some economists believe tax rates will need to be much higher in the future in order to support society’s needs.
Is there a possibility you might need to use your investment soon? With a Roth IRA, you can withdraw your contributions before retirement without paying a penalty in some circumstances. With a Traditional IRA, you’ll need to pay tax on your withdrawals. This could come in handy if you don’t have an emergency fund (you should have an emergency fund) or if your cash becomes depleted for some reason.
Will you live until retirement? If you love high-risk, extreme activities, perhaps you won’t need money in retirement. In fact, the farther you are from typical retirement age — the younger you are — the more likely there is a chance of your retirement being very different from what Americans have known as retirement over the last couple of decades. You may need to work longer, though saving today for retirement can partially offset that need. You may never want to retire, working on something you enjoy until the day you die. It’s hard to say what life will look like 30, 20, or even ten years from now.
Don’t let this decision stop you from investing. The best thing to do is open an IRA as soon as possible if you haven’t already. To generalize, because sometimes that’s easier than actually thinking, if you’re young, investing in a Roth IRA; if you’re older and have established retirement assets already, a Traditional IRA may be the better choice. Work with a company like Fidelity, Vanguard, or TIAA-Cref (avoiding their annuities) that lets you open an IRA immediately even without a sum of money ready to invest. Some companies allow you to start with a small amount as long as you set up a recurring investment.
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