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Welcome Middle Child Money Crew! Today we swing over and talk about retirement and how understanding how different retirement accounts can help you build for and understand your future with more clarity.
Are you confused about traditional and Roth IRAs? Don’t worry! This comprehensive guide explains their key differences in simple terms.
Individual Retirement Accounts (IRAs) are powerful retirement savings tools. They offer tax advantages to help grow your nest egg.
The two main types are the traditional IRA and Roth IRA. Understanding how they work is crucial for effective retirement planning.
What is a Traditional IRA?
A traditional IRA allows tax-deductible contributions for the year made. Your taxable income is reduced by the contribution amount. This provides an upfront tax benefit when you contribute. However, you’ll pay income taxes on withdrawals in retirement. Both contributions and investment earnings are taxed as ordinary income.
What is a Roth IRA?
Contributions to a Roth IRA are made with after-tax dollars. There’s no immediate tax deduction for contributing like traditional IRAs. But qualified withdrawals in retirement are completely tax-free, including earnings! This allows your money to grow tax-free over decades.
Key Differences Between Traditional and Roth IRAs
Tax Treatment
The biggest difference lies in when you get the tax break.
Traditional IRA: Upfront tax deduction, taxed withdrawals in retirement.
Roth IRA: No upfront deduction, tax-free withdrawals in retirement.
Eligibility and Income Limits
Traditional IRAs have no income limits for contributing. But deductibility phases out at higher incomes if covered by a retirement plan.
Roth IRAs have income limits based on filing status. Eligibility phases out at higher modified adjusted gross incomes (MAGI).
Required Minimum Distributions (RMDs)
Traditional IRAs require taking minimum distributions annually starting at age 73. Failure to take RMDs results in a 50% penalty tax.
Roth IRAs have no RMD requirements during the owner’s lifetime. This allows funds to potentially grow much larger over time.
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Required Minimum Distributions (RMDs)
Early withdrawals from traditional IRAs before 59.5 incur taxes plus 10% penalty. There are limited exceptions like disability, higher education expenses, etc.
For Roth IRAs, you can withdraw contributions anytime tax and penalty-free. But earnings may be taxable and penalized if withdrawn early.
Estate Planning
With traditional IRAs, beneficiaries pay income taxes on inherited funds.
Roth IRAs can be passed tax-free to heirs if aged properly.
Which is Better - Traditional or Roth IRA?
There’s no one-size-fits-all answer – it depends on your situation. Remember everyone is on a different financial journey. Your situation might look much different than the next person reading this. Remember there are some benefits in working with a financial advisor. Here are some key considerations for choosing between the two:
Current vs Future Tax Rates
When deciding between contributing to a traditional IRA or a Roth IRA, one of the key factors to consider is your expected future tax rate in retirement compared to your current tax rate. This is because traditional IRA contributions are made pre-tax, providing an upfront tax deduction, while Roth IRA contributions are made with after-tax dollars.
If you expect your tax rate to be lower in retirement than your current rate, a traditional IRA may be more advantageous since you’ll pay taxes on withdrawals at the lower future rate. Conversely, if you anticipate being in a higher tax bracket during retirement, contributing to a Roth IRA could be the better choice, as you’ll pay taxes now at your lower current rate and enjoy tax-free withdrawals later. However, predicting future tax rates is difficult, so it’s often wise to contribute to both account types to diversify your tax exposure in retirement.
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Time Horizon Until Retirement
When deciding between a traditional IRA and a Roth IRA, your timeline to retirement is a crucial factor to consider. If you are closer to retirement age, a traditional IRA may be more advantageous as it allows you to defer taxes on your contributions and investment earnings until you start making withdrawals in retirement. This can be beneficial if you expect to be in a lower tax bracket during retirement compared to your current working years.
On the other hand, if you have a longer time horizon until retirement, a Roth IRA could be the better choice. By paying taxes upfront on your contributions, you can enjoy tax-free growth and withdrawals in retirement, which can be particularly valuable if you anticipate being in a higher tax bracket when you retire due to potential income growth over your career. The longer timeframe also allows your investments to compound tax-free for a more extended period, potentially resulting in greater overall savings.
Estate Planning Goals
When it comes to leaving an inheritance, Roth IRAs offer a significant advantage over traditional IRAs. With a Roth IRA, you contribute after-tax dollars, allowing your investments to grow tax-free. Upon your passing, your heirs can inherit the entire Roth IRA balance without owing any income taxes on the distributions. This tax-free treatment applies to both the contributions you made and the investment earnings accumulated over the years, providing a substantial tax benefit for your beneficiaries.
In contrast, with a traditional IRA, your heirs will have to pay income taxes on any distributions they receive, as the funds were contributed pre-tax and have not been taxed yet. Depending on the size of the inherited traditional IRA and your heirs’ tax brackets, the tax liability could be substantial, potentially eroding a significant portion of the inheritance. By contributing to a Roth IRA, you effectively prepay the taxes during your lifetime, ensuring that your heirs receive the full value of the account without any additional tax obligations.
Ability to Access Funds Early
One key consideration when choosing between a traditional IRA and a Roth IRA is the ability to access funds early without penalties. With a Roth IRA, you can withdraw your contributions at any time, for any reason, without owing taxes or penalties. This flexibility can be advantageous if you need to access your retirement savings for emergencies or unexpected expenses before retirement age.
However, with a traditional IRA, early withdrawals before age 59 1/2 are generally subject to a 10% penalty tax in addition to regular income taxes on the withdrawn amount. There are a few exceptions that allow penalty-free early withdrawals from a traditional IRA, such as using the funds for qualified higher education expenses or a first-time home purchase, but the rules are more restrictive compared to a Roth IRA. If you anticipate needing to access your retirement savings early, the greater flexibility of a Roth IRA could be a significant advantage.
Tax Diversification
Tax diversification is often cited as a reason to contribute to both traditional and Roth IRAs. The idea is that by having money in different tax “buckets,” you can better manage your tax liability in retirement by withdrawing from the accounts in a tax-efficient manner.
However, as the search results explain, true tax diversification is difficult to achieve with just traditional and Roth IRAs. Since the accounts are directly correlated in terms of their tax treatment, contributing to both account types does not actually diversify your risk. Rather than diversifying, it simply neutralizes the potential tax benefits by taking money off the table from a tax planning perspective. To truly diversify your tax exposure, it may be better to strategically contribute to the account type that provides the greatest tax advantage based on your current and projected future tax rates.
Understanding Contribution Limits and Deadlines
When considering whether to contribute to a traditional IRA or a Roth IRA, it’s important to understand the contribution limits and deadlines, which are the same for both account types.
For the 2023 tax year, the contribution limit was $6,500 for individuals under age 50, and $7,500 for those aged 50 and older (catch-up contribution). For the 2024 tax year, the limits have increased to $7,000 for under age 50, and $8,000 for age 50 and above. Be sure to check current rates.
The deadline to make contributions for a given tax year is the tax filing deadline for that year, typically April 15th of the following year. So for the 2023 tax year, you have until April 15, 2024 to make your contributions. And for the 2024 tax year, the deadline will be April 15, 2025.
It’s important to note that these limits apply to the total contributions across all your IRA accounts (traditional and Roth combined) for the year. You cannot contribute the full amount to both a traditional IRA and a Roth IRA in the same tax year.
Additionally, while there are no income limits for contributing to a traditional IRA, the ability to contribute to a Roth IRA starts phasing out at higher income levels. So your income may impact which account type is more advantageous for you.
Qualified Charitable Distributions (QCDs)
Some (please check with your financial or tax advisor) can make tax-free charitable donations directly from traditional IRAs. Called qualified charitable distributions (QCDs), these reduce taxable IRA balances.
QCDs aren’t allowed from Roth IRAs since distributions are already tax-free.
Conclusion
When deciding between contributing to a traditional IRA or a Roth IRA, there are several key factors to consider, including your current and expected future tax rates, your timeline to retirement, inheritance planning, and the potential need for early access to funds.
If you anticipate being in a higher tax bracket during retirement, a Roth IRA may be more advantageous, as you’ll pay taxes now at your current lower rate and enjoy tax-free withdrawals later. Conversely, if you expect to be in a lower tax bracket in retirement, a traditional IRA could be the better choice, allowing you to defer taxes until you start making withdrawals.
For those with a longer time horizon until retirement, a Roth IRA can be particularly beneficial, as it allows for tax-free growth over an extended period, potentially resulting in greater overall savings. However, if you’re closer to retirement age, a traditional IRA may be more advantageous, as it allows you to defer taxes until you start making withdrawals.
If leaving an inheritance is a priority, Roth IRAs offer a significant advantage, as your heirs can inherit the entire balance tax-free upon your passing. Additionally, Roth IRAs provide greater flexibility for early withdrawals, as you can access your contributions at any time without penalties or taxes.
Ultimately, the decision between a traditional IRA and a Roth IRA depends on your individual circumstances and financial goals. It’s essential to consider your current and projected future tax rates, timeline to retirement, inheritance planning, and potential need for early access to funds. Consulting with a financial advisor can also help you make an informed decision that aligns with your long-term retirement objectives.
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The content provided on Middle Child Money is for informational and entertainment purposes only. We are not licensed financial advisors, and the information shared on this blog should not be considered professional financial advice. We encourage all readers to consult with a licensed financial professional to discuss their individual financial situations and needs. The opinions expressed on this blog are solely those of the author, Nate Bradley, and do not reflect the views of any affiliated organizations. Middle Child Money cannot be held liable for any actions taken based on the information provided on this site.
