Traditional IRA vs. Roth IRA
Today we’re going to be discussing a very heated debate. It’s a rivalry for the ages! Rivalries are great, don’t get me wrong, competitions allow for boundaries to be pushed, just like
Frazier versus Ali
Green Bay Packers versus the Chicago Bears
Lakers versus Celtics
The Boston Red Sox versus the New York Yankees
When rivalries exist, the competition gets heated, fans take sides, and the game gets elevated! But unlike sports legends, we’re going to speak about something a little bit more near and dear to my field, the Traditional IRA versus the Roth IRA!
DING DING DING
On one end, we have the heavyweight champion, coming out in 1974 as the only de facto retirement savings account at the time. That’s right, ladies and gents before you were able to save in the Roth IRA or even had an inkling of that financial darling of yours called the 401k, there was the Traditional IRA.
The Traditional IRA was passed into law as a provision for Americans to start saving for retirement. Back before 1974, the most common retirement savings plan was the pension plan. The pension, as most of you are aware, has fallen from the wayside because of the number of resources it needs to keep a pension plan in maintenance. This drain on resources is, of course, due to longevity and an ever-increasingly higher amount of retirement payouts, and as such, companies needed an alternative to retirement savings. The Traditional IRA is individually owned by you and you only, which is why they are called individuals. You can make contributions to the Traditional IRA with what is known as pre-tax dollars. Every dollar you deposit gets deducted from your income, effectively decreasing your taxable liabilities for that year. The funds that are invested grow tax-deferred, meaning you are not subject to capital gains while it is growing in that account. Upon obtaining age 59-½ you can withdraw your principal contributions and any investment earnings, the catch is that you’ll pay ordinary income taxes at that point.
Our contender, the Roth IRA, was not introduced into our financial systems until 1997 by Senator William Roth of Delaware. The Roth IRA, in contrast, allows an individual to contribute after-tax dollars, meaning no tax deductions or reduction on earned income from taxes. Still, it gives that account the ability to grow tax-free, and upon successfully meeting retirement eligibility criteria, withdraw the investment earnings tax-free as well.
We’re going to compare the two, discussing the eligibility restrictions and withdrawals before crowning one as the champion!
Eligibility
The Traditional IRA allows for individuals under age 50 to contribute up to $6,000 and for those over age 50, an additional $1,000 as a catch-up provision. IRAs are individually owned and are tied to your Social Security Number. For households with joint income, you can contribute to both even if one person does not have earned income. This means if one individual is working and the other is a stay-home parent, that household can contribute to both Individual Retirement Accounts up to the annual maximum of $6,000 or $7,000 each.
Anyone over the age of 18 with earned income can contribute towards the Traditional IRA. With the Traditional IRA, if your income is below a specific amount, you are allowed to take a deduction that is partial or in full based on the amount that you contribute.
For single filers, if your income is:
$65,000 or below, you are allowed to take a deduction up to the full amount you contribute. So, if you put in $6,000, you can deduct the total $6,000.
If your income is between $65,000 and $75,000, you can take a partial deduction based on your Modified Adjusted Gross Income, and
If your income is above $75,000, you have no allowable deductions.
For those that are married and filing jointly:
If your earned income is $104,000 or less, you are allowed to take a deduction up to the full amount that you contribute. If you are contributing on behalf of your spouse, that earned income increases to $196,000.
If your income is between $104,000 to $124,000, you are allowed a partial deduction up to the full amount you contribute. For any contributions on behalf of your spouse, the income limitation further increases to $206,000.
You are no longer allowed a deduction on your own Traditional IRA if your household income is higher than $124,000, and deductions cease to exist for your spouse if it is more than $206,000.
One thing to note is that the above numbers on income are about the allowable deductions. If your income is higher than the amount that I referenced, you can still contribute to the Traditional IRA, but you just won’t get the allowable deduction. That money deposited will again grow tax-deferred and taxable as ordinary income at age 59-½ regardless of whether you took the allowable deduction or not.
This now leads us to the Roth IRA. Roth IRAs are also individually owned and have the same contribution limits as the Traditional IRA. It’s the same $6,000 if you’re under age 50 and the corresponding additional $1,000 in catch-up for those over age 50.
The income restrictions on the Roth IRA are easier to understand. You just have to remember two numbers based on your marital status. For single-filers, if your modified adjusted gross income is $124,000 or below, you can contribute the maximum amount to the Roth IRA. For married couples and filing jointly, your modified adjusted gross income must be below $196,000. The way the tax code works, as your income steadily increases above those two numbers, the maximum amount that you can contribute decreases. So, for instance, if I’m married and my MAGI is $200,000, that means my maximum allowable contribution to the Roth IRA is only $3,600 per individual.
The upper limit on your MAGI is $139,000 for single filers and $206,000 for married filing jointly. If you earned more than those numbers, you are ineligible to contribute to the Roth IRA.
So what happens if you want to have a tax-free investment account, but your income is over the threshold I just mentioned? Well, there is a little-known tax loophole for individuals or families that earn more than that. This little strategy known as the backdoor Roth IRA contribution allows for contributions even if your income is higher than those numbers.
The backdoor Roth contribution is a fantastic way for those who love the concept of tax-free money. I’ll have a separate episode on the Backdoor Roth IRA, so if you’re above the income limits and want a tax-free retirement savings account, be sure to check that out!
Numbers-wise, the income eligibility is pretty neck in the neck, but because of the lower amount of allowable deductions as your income increases above the thresholds, and the ability to withdraw tax-free from the Roth IRA makes this round in favor of the Roth IRA.
Withdrawals
Now, I’ve already stated that withdrawals from a Traditional IRA are permissible upon attaining age 59-½. Withdrawals at that age forward will only be subject to ordinary income taxes. Withdrawals before age 59-½ will be assessed as average income taxes plus an additional 10% penalty. Remember, everyone; these accounts are designed for retirement, which is why the IRS has a steep charge for withdrawals before that. Don’t tap this account for emergencies or use it for vacations because that can effectively cost you close to 30%!
So what happens if you need to use the funds sooner? Well, it depends on what you’re using it for. The IRS has specific exclusions for withdrawals before age 59-½. These are limited to:
First time home purchase allows for a withdrawal of up to $10,000 in your lifetime.
Higher education expenses for yourself and immediate family
Disability
Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income
Birth or adoption expenses have an allowable amount of up to $5,000
Health insurance premiums if you have been unemployed for at least 12 weeks.
Withdrawals based on those criteria above are still subject to ordinary income taxes but not the 10% penalty.
Additionally, if you are retiring early, before age 59-½, there is an IRS provision that allows for you to take funds out without that 10% penalty. The 72T arrangement is structured for early retirees, but they must maintain a periodic payment that is predetermined. This rule is pretty in-depth, so I’ll be uploading a separate episode on the 72T for those interested in early retirement income.
Traditional IRAs are subject to required minimum distributions, otherwise known as RMDs. The IRS states that when you turn age 72, you must take a minimum amount from your Traditional IRA every year. Please note that before the Secure Act ruling, the RMD age was 70-½. If you turned 70-½ in 2019 and was subject to the RMD, you must follow that schedule. It is only for those whose birthdays are after March of 1951 that they can use the age 72 RMD rule.
I often get asked why the RMD rule is in place, and in short, the answer is taxes. Think of the Traditional IRA as this tax-sheltered account where you have been putting in pre-tax dollars, and the investments have been growing tax-deferred. The IRS is just waiting for you to take it out because that is when they get their tax payments! The IRS doesn’t want the millions of Traditional IRAs floating out there to go untapped because the tax revenue faucet will start drying up. It is that simple.
So, going back to the RMD-the RMD starts at age 70-½ or 72 depending on your birthday, and it incrementally increases each year. There’s an actuarial table based on life expectancy that determines how much needs to be taken out each year as calculated on the previous years' December 31st year-end account balance. It starts at roughly 4% which isn’t very high, but it quickly gets up to 10% in your late 70s, early 80s, and by the time you’re in your 90s, it is not uncommon to see required minimum withdrawals as high as 30 to 40% of the account balance.
When it comes to the Roth IRA, it’s common for most investors to think that there aren’t any provisions they need to be concerned about for withdrawals, which is simply not true!
The Roth IRA is filled with after-tax contributions, the investments grow tax-free, and when taken, it provides a tax-free income if you meet two criteria: you must be age 59-½ or older, and you must have had that account for at least five years to withdraw your earnings tax-free.
When it comes to your contributions, you can withdraw that at any time without any problems. The earnings are what matters. The five-year account history is critical to remember. If you started your Roth IRA at age 58 and you made your contribution at that age, you cannot effectively withdraw the earnings from the Roth IRA at age 59-½. If you do that, your investment earnings are subject to the tax penalty of 10%. The earnings must sit in that account for a full five years before you can withdraw it without the penalty.
The Roth IRA has the same exclusions as the Traditional IRA; you take investment earnings out for purposes of your first home purchase, higher education, medical expenses, birth or adoption, etc.
The Roth IRA, however, is not subject to the RMD rules. I repeat, it is not subject to RMD rules, so when you turn 70-½ or 72, you are not required to take any money out of that account if you do not want to. This is a crucial differentiating factor, and the second most important reason why you should have a Roth IRA. While your Traditional IRA will start whittling down in account value as the IRS forces you to take an ever-increasing amount, the Roth IRA allows you to maintain a growth-oriented approach and continue to save your nest egg for later years.
This differentiating factor is critical to your financial plan. Often, when I’m creating retirement plans, we have the immediate pressing need, which is retirement income. Most of the people that come to me are wanting to know how much they can take in retirement and if that amount is acceptable to their living standards. That’s easy enough, but a more significant part of what our planning revolves around is late-stage unexpected medical expenses or legacy building.
You and I both know that as we get older, things are going to get more expensive. It’s called inflation, our cost of goods continuously go up every year. The cost of medical treatment is expected to increase. Assisted living or long-term care, which you and I hate to think ourselves ever needing to be in, can cost upwards of $5,000 a month! Here in Arizona, the cost of assisted living or long-term care starts at $4,500. In San Francisco, where my family is from, it starts at $5,500 a month!
So, throughout this entire retirement time frame, assuming you retire at say age 67, you’re withdrawing enough money to maintain your lifestyle, you’re traveling, and enjoying life. This whole time, the IRS is forcing you to take money out every year to ideally have you run out of money by the time you’re in the 90s, and bam you’re hit with a medical condition that requires long-term care. My question is, where’s that money going to be coming from if you’ve been withdrawing from your nest egg this entire time?
The Roth IRA gives you the ability to save for retirement for tax-free income. Still, in addition to that, if you stick with a solid financial plan and find that between all your other income sources, you do not need more money from the Roth IRA, you can continue to let that defer and grow for late-stage health expenses. I do this often with my clients where we position the Roth IRA as such so that they don’t get caught in an “oh snap” moment.
So, tax-free income and lack of required minimum distributions mean the Roth IRA gets another win in this battle.
Ok, everyone, when it comes to eligibility, exclusions, tax liabilities, and flexibility, the Roth IRA, without a doubt, wins hands down. Inserting a Roth IRA into your financial plan is simple enough, and anytime you have extra funds to invest, I encourage you to look at maximizing your Roth IRA if you have not done so already.
If you have any questions on setting up a Roth IRA or need help with the investments on the Roth IRA, please be sure to drop me a line and my team and I would be more than happy to help you.
Thanks for tuning in! Until next time, I wish you a productive week!.