Traditional IRA Vs Roth IRA – Why It Matters

21930623_sEach year I volunteer at my undergraduate alma mater, Massachusetts Maritime Academy, to teach a three-hour course to the graduating class on planning and setting up their financial future. It is a great opportunity for me to get to know these fine young men and women and to reflect on how fast 25 years have passed since I was in their seat.
My goal in teaching the class is to make these young adults start thinking about and planning for their financial future. One cadet, Robert, asked about something that many of you, Cutter Family Finance readers, should also understand. He asked, “What are the differences between a traditional and a Roth IRA and why should it matter to me?” I was impressed that a 21-year-old would know enough to ask such a question.
I told Robert and the rest of the cadets that choosing between a traditional IRA and a Roth IRA can significantly affect long-term savings. So it is worth understanding the differences between them in order to make informed decisions.
Let me explain to you what I explained to them. You see, both traditional and Roth IRAs provide generous tax breaks, but it’s a matter of timing when you get to claim them. Generally, traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with traditional IRAs, you avoid taxes when you put the money in. With Roth IRAs, you avoid taxes when you take the money out.
Therefore, it is important to consider whether your expected income, and resulting income tax, will increase or decrease in retirement. In other words, is it likely that the tax rate you would pay on Roth IRA contributions (today’s tax rate) is higher or lower than the tax rate you would pay on withdrawals from a traditional IRA in retirement?
Of course, it’s hard to predict what federal and state tax rates will be 10, 20 or even 40 years from now. But you can ask yourself some basic questions to think about your personal situation: Which federal tax bracket are you in today? Do you expect your income, which will include Social Security benefits, to increase or decrease in retirement?
Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about this. Once the kids are grown and you stop saving for retirement, you lose some valuable tax deductions and tax credits, sometimes leaving you with higher taxable income in retirement.
What about tax rates generally? I asked Robert whether he expects tax rates to be higher or lower when he retires based upon current fiscal and political policies? “Higher?” he asked.
Hmm … that Robert is a smart kid! And if he’s right, that logic leads to the conclusion that Roth IRAs may be the better long-term choice.
Another consideration in choosing between a traditional IRA and a Roth IRA, which I explained to the cadets, is contribution limits. Anyone with earned income, who is younger than 70 1/2, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions. Single tax filers, for instance, must have modified Adjusted Gross Income of less than $129,000 in 2014 to contribute to a Roth IRA. (Contribution limits are phased out starting at $114,000 in modified AGI, per IRS guidelines.) Married couples filing jointly must have modified AGI of less than $191,000 in 2014 in order to contribute to a Roth. (Contribution limits are phased out starting at $181,000.)
I explained to the class that another major difference between traditional IRAs and Roth IRAs is that traditional IRAs require minimum distributions (RMDs) beginning at age 70 1/2. Roth IRAs, on the other hand, do not mandate withdrawals during the owner’s lifetime. So, if you don’t need the money, Roth IRAs can continue to grow tax-free throughout your lifetime, making them ideal vehicles with which to transfer wealth. Beneficiaries of Roth IRAs do not pay income tax on withdrawals and can stretch distributions over many years.
Both traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59 1/2. However, Roth IRAs require that the first contribution be at least five years before qualified distributions begin. Roth contributions (but not earnings) on the other hand, can be withdrawn penalty and tax-free any time, even before age 59 1/2.
This kid was really getting it, so I went on further to explain a few more things to consider when choosing between traditional and Roth IRAs. As mentioned above, contributions to traditional IRAs generally can lower taxable income in the contribution year, which lowers adjusted gross income, thereby making some additional tax incentives available, such as the child tax credit and/or the student loan interest deduction. (This is important to Robert, since he has student loans.)
Another consideration for him is that up to $10,000 can be withdrawn from a traditional IRA without the normal 10 percent early-withdrawal penalty, if the funds are used to pay for qualified first-time homebuyer expenses. However, income taxes must be paid on the distribution, which can drastically eat away at the benefit. Five tax years after the first contribution, up to $10,000 of Roth earnings can also be withdrawn penalty-free to pay for qualified first-time homebuyer expenses.
Three hours after we began, we finished the class and took some pictures together. I wished them all well and said good-bye. As I drove home, I could not help but reflect on my past 25 years, specifically about financial decisions I have made and how they have impacted my life.
Be vigilant and stay alert, because you deserve more!