As I think most of us are aware, there are (2) types of IRAs – a Traditional and a Roth. These options are growing in availability within employer-sponsored retirement plans, and I think some explanation about the difference is warranted.
Traditional accounts are tax-deferred, meaning the money put into the account is not taxed and thus your annual income is lowered. For example, if you are earning $80,000 a year and you’re filing Married Joint, you would start in the 25% bracket. If you contribute 6% of your income to a traditional retirement plan (401k, 403b) your taxable income drops to $75,200 and you end up in a lower tax bracket (15%). The downside is eventually the money will be taxed. The IRS mandates in most cases withdrawals need to start by the time you turn 70 ½; exceptions being made if you are still working and actively contributing to a 401k. When you start taking these withdrawals (distributions), the money withdrawn will be taxed as income.
Additionally, the IRS is going to tell you how much money you need to withdraw – required minimum distributions. They provide a worksheet, here; but if you have any difficulty figuring out how much you need to withdraw I recommend you talk to a professional. If you don’t take your required minimum distribution you’re looking at a 50% penalty!
For example, you’ve retired and are required to withdraw $60,000 per year. If you and your spouse are earning $45,000 in social security, your household income is going to jump to $105,000 per year, putting you in a higher tax bracket.
A Roth account, on the other hand, does not have any immediate tax benefits – your contributions are made after tax. So, using the above example, if you earned $80,000 and contributed 6%, you would still be taxed at $80,000. The benefit is experienced in retirement – you can withdraw as much as you want without paying any income taxes. So, in the above example, if you don’t need an additional $60,000 per year, you aren’t required to withdraw it.
Both Roth and Traditional IRAs will have income limits defining when you can contribute to them. Additionally, the maximum you can contribute to either/both is $5,500 per year ($6,500 per year over the age of 50). For example, if you contribute $3,000 to a Roth IRA and then want to contribute to a Traditional IRA, the contribution limit is $2,500 ($5,500 total).
How do you know which is right for you? It comes down to how much you can afford to have withheld from your paycheck every month, because contributing 10% to a Roth retirement account is going to be felt much more than 10% to a Traditional. It’s also important to factor what your tax bill is now, and what you think it will be in retirement. For example, if you know you’ll be receiving a pension, or pensions for those of you who retire from the military and government service; you’ll probably be better off from a tax perspective using the Roth option. When in doubt, reach out to a financial planner.