IRA vs. Roth IRA
Given the option, would you prefer to be taxed now or later? This is a question essential to the decision of whether to invest in a Roth IRA as opposed to a traditional IRA, but the answer is not as straightforward as it may appear to be.
As noted in a prior blog post, the first retirement account to which you should contribute is the one sponsored by your employer. This is likely to be a 401(k) or 403(b) plan. After contributing enough of your salary to ensure you receive the maximum employer contribution, you may have additional money that you would like to invest for retirement.
That’s when you might consider an IRA or a Roth IRA. An Individual Retirement Arrangement, or “IRA”, is not tied to your employer and can be set up through a broker or investment management company such as Schwab. The benefit of these accounts is that they allow for the tax-free or tax-deferred growth of investments. The primary difference between a traditional IRA and a Roth IRA is the deductibility of contributions. Contributions to a traditional IRA are known as pre-tax contributions, as they are tax-deductible in the tax year in which they are made, but withdrawals made in retirement are taxed. Roth IRAs are funded with after-tax contributions, as they do not offer a tax benefit for contributions in the year they are made, but taxes are not owed on withdrawals in retirement.
At first glance, it may seem that the traditional IRA is the better deal since it offers a tax benefit to you sooner. However, assumptions about the future must be made in order to determine which account will maximize the future value of your retirement assets. Tax rates, income level, and liquidity needs are some of the factors to consider, and while current values for these may be easy to determine, it is harder to predict what they will be in retirement.
If you assume that tax rates will be higher in the future, it might make more sense to stomach today’s tax rates and avoid paying higher, future tax rates by investing money in a Roth IRA. As an example, let’s assume that you have 40 years to retire, and you expect to earn a rate of return of 5% annually on your investments. Also, your federal marginal tax rate is currently 12% and you expect it to be 24% when you retire. If you have $6,000 pre-tax to contribute to one of these accounts this year, a single Roth contribution, which would in this case be an after-tax contribution of $5,280, would have an after-tax value of approximately $37,171 at retirement. A traditional IRA contribution of $6,000 would only have an after-tax value of about $32,102 at retirement. If you were to switch the tax rate assumptions so that your current tax rate is 24% and your tax rate in retirement is 12%, the Roth’s value at retirement would be $32,102 and the traditional IRA’s after-tax value would be $37,171, making the traditional IRA more attractive. It is important to note that these calculations assume the traditional IRA is liquidated and taxed the moment you retire, which is an unlikely scenario given that other sources of income may be available to you and IRAs are typically liquidated over many tax years.
Liquidity is another consideration. Since traditional IRA contributions are made with pre-tax dollars, they should generally be considered “off limits.” An early withdrawal from an IRA is included in gross income and taxed at your marginal rate. Additionally, a 10% penalty is charged if a withdrawal is made prior to age 59½, although there are some exceptions. For example, if you use the funds before 59½ to pay for a medical insurance premium after a job loss, then you’ll be subject to ordinary income taxes but not the 10% penalty. By comparison, because Roth contributions are made with after-tax dollars, you can withdraw your contributions tax free – providing you with a source of emergency liquidity. Keep in mind, however, that earnings on a Roth withdrawn before the age of 59½ are subject to a 10% penalty, with some exceptions. For example, up to $10,000 of gains may be distributed tax-free if they are used for the purchase of a home and you have not owned one in the previous two years.
At the same time, traditional IRAs do have their own liquidity benefits relative to Roth IRAs, because they offer a tax benefit today. If you would like to contribute $3,000 to an account, and if you were to contribute this to a Roth, you would need $3,947 in pre-tax income assuming a tax rate of 24%. $3,000 would go into your Roth and $947 would be paid in taxes. Instead, if you were to make a $3,000 contribution to a Traditional IRA, you would have $947 of taxable income left over from the original $3,947. After taxes, you’d be left with $720 in your pocket, thereby increasing your liquidity. In other words, you’d still have your $3,000 of tax-deferred money in your IRA plus $720 in your savings account or taxable brokerage account.
There are a number of rules to keep in mind when determining whether or not you meet the requirements for contributing to a traditional IRA or Roth IRA. For Roth IRAs, there is a phase-out based on your modified adjusted gross income (MAGI). If you are single with MAGI less than $124,000 or if you are married filing jointly with MAGI less than $196,000, you can make a full contribution of $6,000 ($7,000 if over the age of 50) in the 2020 tax year. Contribution eligibility phases out for those married filing jointly in the $196,000 to $205,999 range. The phase out range is $124,000 to $138,999 for a single filer. Those with MAGI above these limits are ineligible for Roth IRA contributions entirely.
For those covered by a retirement plan at work, traditional IRA contributions are fully deductible for those married filing jointly with MAGI of $104,000 or less. For joint filers with MAGI between $104,000 and $124,000 the deduction is reduced, and no deduction is allowed if MAGI is above this range. For single filers, the full deduction is applicable if MAGI is $65,000 or less, with a partial deduction if it is between $65,000 and $75,000. No deduction is allowed above this range. Contributions to both kinds of accounts cannot exceed the annual maximum. In other words, you can make a $3,000 contribution to a Roth IRA and a $3,000 contribution to a traditional IRA, as long as the total does not exceed $6,000 in the 2020 tax year.
We do not know what tax rates will look like in the future, and predicting one’s future income is not an exact science. Because of this, we recommend diversifying between pre-tax and after-tax retirement accounts. Traditional 401(k) and 403(b) contributions are made with pre-tax dollars, like those made to a traditional IRA. Therefore, if you have a traditional 401(k) or 403(b), it may make sense to contribute to a Roth IRA to diversify your tax exposure. But there are a number of details related to your personal situation that need to be considered, including your income level and liquidity needs, to determine which options are best for you. A financial advisor and tax professional can help you work through these questions.