Being a financial advisor, I love numbers and taxes, some people may call me a geek. But that personality trait is what causes me to want to share with people some of the more technical aspects of the financial issues that we face in the industry.
In my opinion, the financial world is not a place to paint in broad strokes, but many do. And unfortunately, investors often do not have the information necessary to understand the differences between similar financial vehicles and strategies. Case in point: in a recent TIAA survey, 56 percent of respondents reported that there is no difference between one type of IRA account and another.
That, Yields4u Family Finance readers, is wrong. Not all IRAs are the same, and understanding the differences between them is essential in determining which kind is the correct one for your needs.
This week, I would like to discuss two types of IRAs that most people are familiar with - the traditional IRA and the Roth IRA - and some of the distinguishing features of each.
The main difference between the two is the way they are taxed. Both traditional and Roth IRAs have contribution limits of $6,000 a year ($7,000 if you are older than 50), to the extent of earned income. If you contribute that money to a traditional IRA, generally, you can deduct that contribution from your taxes in the year you make the contribution, but all distributions are taxable when the money is withdrawn. (Your ability to deduct contributions may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.) The opposite is true with a Roth. The contributions are not tax-deductible in the year they are made, but there are no taxes due when you withdraw the money.
What does this distinction mean to you? Well, if you expect to be in a higher tax bracket when you withdraw the funds than you are now, it may make sense to pay taxes on that money when you make the contribution—use a Roth IRA. If you find yourself in a very high tax bracket now and expect to be in a lower bracket in the future, contributing to a traditional IRA might be a better decision. It is helpful to remember the seed versus harvest metaphor here. Would you rather pay taxes on a small bag of seeds (the contribution for a Roth) or pay taxes on the harvest that results from those seeds (as you do with a traditional)?
Another important distinction is that once you put money in a traditional IRA, you cannot touch it (without a penalty, that is) until age 59 1⁄2, except for in limited circumstances. With a Roth IRA, you are able to withdraw any of the principal (the amount you have contributed post-tax) at any time, even prior to age 59 1⁄2. However, if you take a distribution of Roth earnings prior to age 59 1⁄2 and before the account is five years old, the earnings may be subject to taxes and penalties. Under certain, limited exceptions, penalties (but not taxes) can be avoided for such distributions. If you take a distribution of Roth earnings prior to age 59 1⁄2 and the account has been open for a minimum of five years, then your earnings will not be subject to taxes (or penalties) under those same limited exceptions. Lastly, if you are older than 59 1⁄2 but you have not met the five-year holding requirement, your earnings will be subject to taxes but not penalties.
It is also wise to think about how the differences between these two kinds of IRAs will affect you when you reach age 70 1⁄2. With a traditional IRA, you need to start taking required minimum distributions (RMDs). In other words, you will be required to withdraw (and pay taxes on) a certain percent of your traditional IRA, every year. If you fail to take the RMD from a traditional IRA, you may be subject to a 50 percent penalty on the amount that was not taken.
With Roth IRAs, there are no RMDs if you are the original owner of the account. The money in your Roth can keep growing, tax-free, year after year, no matter your age. If you do not need it, you do not need to touch the money in your Roth. This can be quite valuable, considering the benefits of compounding growth.
You may be thinking that a Roth IRA is a great retirement savings vehicle, and in many cases it is. However, it is not always an option. There are income limits for Roth IRAs that can keep many people from contributing to one. For 2019, if you are single with $137,000 of modified adjusted gross income (MAGI), you cannot contribute any amount to a Roth IRA, and if you are a couple filing taxes jointly with MAGI above $203,000, you cannot contribute to a Roth.
As I explain to many of my clients, the designation of an account as being either a traditional IRA or a Roth IRA is just the tax classification of that account. Equally important to understand with respect to a retirement savings account is the type of investment strategy used in the account and whether that strategy is in line with expectations of risk versus return.