Written by Greg Palacorolla, CFP®
Because pensions and other defined benefit programs are rapidly being phased out, saving for retirement via 401(k) plans and IRA’s is essential to the future financial success of individuals and families. The first step is recognizing the importance of saving for retirement and accepting the sacrifice of immediate disposable income. 401(k) plans are understood by most individuals because of the commonality of them as a company benefit. However, another powerful investment vehicle that supplements 401(k) plans and provides significant tax benefits to owners is an Individual Retirement Account (IRA). Traditional IRA and Roth IRA’s are the most common types, each offering specific and unique benefits to the owner. The dilemma for many is choosing which one is better for their specific situation. When asked the question of which type of IRA is better, traditional IRA or Roth IRA, my answer: It depends.
Understanding the Traditional IRA
A traditional IRA is funded with pre-tax dollars and grows tax-deferred until you are eligible to withdraw—age 59.5. You are not responsible to pay tax on capital gains or dividends, which allows your investments to compound and grow more rapidly. When distributions begin, gains are treated as ordinary income which is subject to income tax. The maximum annual contribution is $5,500, unless you are over age 50 and you may increase your contribution to $6,500.
Advantages of the Traditional IRA
One feature of a traditional IRA that is appealing to investors is the potential for the contribution to be tax-deductible. The ability to deduct your contribution hinges on your income level, as well as your participation in a retirement plan through your employer. If an income tax deduction is taken in the contribution year, you must pay income tax on those contributions when you take the distribution; whereas if you do not deduct the contribution, you are only subject to income tax on the growth of the account (account value minus contributions).
Early Withdrawals from a Traditional IRA
If withdrawals out of the IRA are made prior to age 59.5, the distribution is taxable and a 10 percent penalty is imposed. The penalty can be avoided if the funds are used for:
- A first-time home purchase
- Education expenses
- Unreimbursed medical expenses
- Health insurance for an unemployed person
At age 70.5, the IRS mandates the account holder to take a required minimum distribution (RMD) from their account which is taxable, thus ceasing the tax-deferred growth on that portion of the funds.
Understanding the Roth IRA
Contrary to the traditional IRA, the Roth is funded with after-tax dollars. The major difference with the Roth IRA is the tax-free growth that results. Contributions to Roth IRA’s are not tax deductible. Since contributions are made with after-tax dollars, all distributions in retirement by the investors are tax-free. Annual contribution limits of $5,500 ($6,500 if over age 50) and eligibility restrictions based on your adjusted gross income exist.
Early Withdrawals from a Roth IRA
Withdrawals from Roth IRA’s are more flexible than a traditional IRA. A qualified distribution is tax- and penalty-free, provided that the five year holding requirement is met, and any of the following conditions are satisfied:
- Over age 59.5
- Death/ disability
- A first-time home purchase
If a non-qualified distribution is taken, earnings are subject to income tax and will be assessed a 10 percent penalty. However, at any time, your basis (total contributions) can be withdrawn penalty free.
Advantages of the Roth IRA
Another significant advantage to the Roth IRA is the absence of RMD’s, allowing you to extend the tax-free growth of funds without the requirement to withdraw. The Roth IRA then becomes an estate planning vehicle. Often times to maximize this tax-free investment, Roth IRA’s are kept in place until death, at which time they are passed to the account owner’s beneficiary who will continue to capitalize on the tax-free status of the account.
Deciding between a traditional IRA and a Roth IRA truly depends on an individual’s personal financial situation. The major question that needs to be answered is: Do you want to reap immediate or future tax benefits? Typically, you would want to reap the immediate benefit, but what if the future benefit is significantly larger?
When the Traditional IRA Is a Better Fit
For our clients who are older, further into their careers, and earning more, the traditional, deductible IRA (if they qualify) if often used. When combining a 30-35 percent federal tax bill with a 5-10 percent state liability, the benefit in deducting that on your current income tax return is substantial. Since the tax is deferred, the assumption is your tax bracket will be lower in retirement. Therefore, receiving 40-45 percent of your contribution now via reduced income taxes or a refund coupled with a lower tax bracket in retirement is enticing.
When the Roth IRA Is a Better Fit
However, a young professional with a salary that places him or her in the lowest tax bracket would not reap as sizable of an immediate tax benefit (20-25 percent vs. 40-45 percent). Their tax bracket in retirement is unlikely to be much, if any lower than the bottom bracket today. In addition, chances are tax rates continue to rise in the future, not fall. Therefore, if the income tax savings on the contributions are inconsequential, the Roth IRA becomes more attractive.
Consider Your Time Frame for Growth Potential
The second major consideration when deciding between the two IRAs is your personal time frame. For our younger clients who have 30-40 years of growth potential, the Roth IRA makes a lot of sense because of the substantial compounding that will occur over time, without the liability of paying any tax. An individual that is approaching retirement has a much shorter timeline, therefore less time to maximize growth. Clients who are looking to limit their current income tax liability, which is typically clients in higher tax brackets, the deductible traditional IRA achieves their objective. Take the deduction on your higher income now and pay the tax in retirement when your income is likely to be lower than in the midst of your career. Eligibility and/or restrictions based on income levels and participation in other retirement plans through your employer may eliminate the availability of a certain IRA, thus making your choice easier.
As you can see, there are pro’s and con’s to each type of IRA, in addition to several key factors to consider:
- Income tax situation
- Time frame, flexibility
- Rate of return on investments
At Geier Asset Management, we are here to help analyze these factors, build projections that illustrate the growth of the account, and incorporate your complete financial picture into the decision. Also, the decision does not need to be all or none. You may be able to split your contributions between the two IRA types and potentially enjoy the benefits of both discussed above, providing even greater flexibility in your retirement years.
You make the decision to save for retirement and we’ll help you determine which vehicle makes the most sense. However, as you can see, the answer is never crystal clear. Therefore, when a client asks me which IRA to fund, my answer is simply, “It depends.”
© Geier Asset Management, Inc. November 2014. Greg Palacorolla is the Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Palacorolla and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.