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Traditional or Roth IRA, or maybe you need both?

Retirement Planning College Planning Investment Management Tax Planning

Traditional IRAs and Roth IRAs offer different benefits—but having both can make sense.

Key Take Aways- 

  • Taxes are a key consideration in deciding between a Roth IRA and a traditional IRA.
  • Flexibility should be considered as well: A Roth IRA allows you to withdraw your contributions anytime, with no taxes or penalties due.
  • It may make sense to contribute to both types of IRAs if you are eligible, so you have tax-free and taxable options when you withdraw the money in retirement.
  • To make the most of your IRA savings, invest the money for long-term growth.

You're ready to save for retirement in an IRA. But wait, there are 2 types of IRAs—a traditional IRA and a Roth IRA. Which one should you choose? You may be able to contribute to both types. Here are some things to keep in mind as you decide which is the appropriate choice for you now.

In 2022, the annual contribution limit for IRAs, including Roth and traditional IRAs, is $6,000. If you're age 50 or older, you can contribute an additional $1,000 annually.

To be eligible to contribute the maximum amount in 2022, your modified adjusted gross income must be less than $129,000 if single or $204,000 if married and filing jointly. Contributions begin to be phased out above those amounts, and you can't put any money into a Roth IRA once your income reaches $144,000 if a single filer or $214,000 if married and filing jointly.

There is a taxable compensation requirement to contribute to an IRA. You, or your spouse, must have taxable compensation of at least your contribution amount.

Which kind of IRA?

With a traditional IRA, your contribution may reduce your taxable income and, in turn, your federal income taxes if you are eligible for the tax deduction. Earnings can grow tax-deferred until withdrawn, although if you make withdrawals before age 59½, you may incur both ordinary income taxes and a 10% penalty.2 (There are a handful of situations that may qualify for waiving the early withdrawal penalty.) After age 59½, you may make withdrawals of any amount without penalty, but federal and state taxes may apply. Starting in the year you reach age 72,3 you will need to begin taking at least the required minimum distributions (RMDs) and paying ordinary income taxes on the distribution amount.  To estimate your tax savings on a traditional IRA contribution, you'll need your marginal tax rate. Then multiply it by the amount of money you contributed to your traditional IRA. That's generally how much a traditional IRA may reduce your federal income tax. (Keep in mind that it's an estimate. In some cases your contribution can reduce your marginal tax rate, so your federal tax savings might be smaller. On the other hand, you might also save on state income taxes. And your deduction may be limited based on your MAGI) Hypothetically, a person with a 24% marginal federal income tax rate could save up to $1,440 in taxes on a contribution of $6,000, if the person is fully eligible for a tax-deductible contribution to the IRA.

While everyone with taxable compensation can contribute to a traditional IRA, if you and/or your spouse also have access to a workplace plan such as a 401(k), your ability to deduct your traditional IRA contribution may be limited, so you may want to prioritize the workplace plan. The most common types of workplace plans, 401(k)s, 403(b)s, and 457s, allow participants to save more than 3 times the annual IRA contribution limit. Contributions to these types of accounts can be made pre-tax, as opposed to IRA contributions that are made after-tax. This means the tax benefits can be realized each paycheck, opposed to a tax deduction at the end of the year.

With a Roth IRA, your contribution isn't tax-deductible the year you make it, but your money can grow tax-free and your withdrawals are tax-free in retirement, provided that certain conditions are met. Eligibility to contribute to a Roth IRA does not depend on a retirement plan at work for you or your spouse. As long as your MAGI is below the annual limit and you have taxable compensation equal to or greater than your contribution, you can contribute to a Roth IRA.

Earnings on those contributions (although not the contributions themselves) may be subject to both tax and early withdrawal penalties if withdrawn before the qualifying criteria are met. As with the traditional IRA, there are some circumstances that qualify for an exception to the 10% penalty—like buying a first home or paying qualified educational expenses. Because Roth contributions are made after taxes have been paid, you can withdraw your contributions anytime, with no taxes or penalties due.

Unlike traditional IRAs, Roth IRAs do not have RMDs (during the original owner's life).

Spousal IRA

If your spouse doesn't work, they can have a spousal IRA. This allows non-wage-earning spouses to contribute to their own traditional or Roth IRA, provided the other spouse is working and the couple files a joint federal income tax return. If the working spouse is covered by a retirement plan at work, deductibility of contributions to a spousal traditional IRA would be phased out at higher incomes. This means eligible married spouses can each contribute up to the contribution limit each year to their respective IRAs. Spousal IRAs are also eligible for a $1,000 catch-up contribution for those 50 and older.

Making a decision

If you are eligible to contribute to either IRA and receive a deduction for traditional IRA contributions, it is worth considering what your tax rate might be when you begin taking withdrawals. If your tax rate will be lower in the future, a traditional IRA may help you make the most of your tax benefits as you can take the deduction on your contribution this tax year and pay taxes on withdrawals in the future at a lower rate. The opposite may be true for Roth IRA contributions. If your tax rate is lower now than when you begin taking withdrawals, you may maximize your tax benefits by making a Roth IRA contribution this tax year and receiving tax free withdrawals in the future, assuming you have met the eligibility requirements.  But tax rates don't tell the whole story. 

How disciplined you are at saving can also play a role in which type of account may better help you prepare for retirement? Here's why. Generally, deductions from contributions to a traditional IRA can help lower your taxable income, if you are eligible, giving you more money in your pocket. These tax savings help improve your retirement picture only if you're disciplined enough to save. If you tend to spend any money left at the end of the month, or any income tax refund, it's not going to help your bottom line when you retire. Of course, on the other hand, the tax savings may provide an extra incentive to save now that Roth IRAs don't offer.

With Roth IRA contributions, you won't get a tax deduction up front. But if you (like many people) tend to spend all your discretionary income, having less disposable income might be a good thing when it comes to your retirement savings. In a sense-switching from a traditional IRA to a Roth IRA forces you to save more for later by keeping less in your pocket now, assuming you keep making the same contribution. Roth IRAs have additional advantages that go beyond taxes. Because you don't need to take RMDs with a Roth (during the life of the original owner) and because the assets in a Roth account can be bequeathed to your heirs income tax-free, Roth accounts can be a useful estate planning tool. Not eligible to contribute to a Roth IRA because your income is too high? You can convert a traditional IRA to a Roth IRA, though you will need to pay taxes on the conversion. (Non-deductible contributions converted to a Roth IRA won't be taxed unless you have any IRA containing deductible contributions, in which case, taxes are applied proportionally by balance.)

Having it both ways

It may be appropriate to contribute to both a traditional and a Roth IRA—if you can. Doing so will give you taxable and tax-free withdrawal options in retirement. Financial planners call this tax diversification, and it's generally a smart strategy when you're unsure what your tax picture will look like in retirement.

For example, with a combination of traditional and Roth IRA savings, you could take distributions from your traditional IRA until you reach the top of your income tax bracket, and then withdraw whatever you need beyond that amount from a Roth IRA, which is tax-free, provided certain conditions are met.

On the other hand, taxes in retirement may not be the whole story. Reducing your current taxable income through traditional IRA contributions may also be advantageous for other reasons, such as qualifying for student financial aid.

There's still one more tax benefit available to some taxpayers: the saver's credit. Eligibility is based on your adjusted gross income (AGI). The maximum credit available is $1,000 (single) or $2,000 (married filing jointly). Depending on your AGI, you could get a credit of up to 50% of your contribution to an IRA or workplace retirement plan. The amount of the credit goes down as income goes up, phasing out at $33,000 (single) and $66,000 (married filing jointly) in 2021, $34,000 (single) and $68,000 (married filing jointly) in 2022. For more information visit the IRS's Retirement Savings Contributions Credit

Investing an IRA contribution

Many people make their IRA contribution just before the tax deadline and after they have determined their MAGI for the tax year, and put the contribution into a money market fund. Then they never go back and choose a growth-oriented investment. This is generally not ideal. One of the best ways to give the money a chance to grow over the long term is by having an age- and risk-appropriate level of diversified exposure to stocks—in the form of mutual funds, ETFs, and/or individual securities. Of course, that means getting used to riding the ups and downs of the market.

Consider this hypothetical projection: One $6,000 contribution could grow to approximately $64,000 in 35 years.7 (We used a hypothetical 7% long-term compounded annual rate of return and assumed the money stays invested the entire time. Investments that have the potential to return 7% annually are generally those that come with some risk, such as stocks.)

If the $6,000 amount seems daunting, even if you can put only $550 into an IRA and leave it there invested for 35 years, earning a hypothetical annual return of 7%, it could be worth nearly $5,900 in 35 years. Make that $550 contribution every year and it could be worth over $87,000 after 35 years, using a hypothetical annual rate of return of 7%. (Note: These examples do not take into account taxes, inflation, or fees.)

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