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Roth IRA vs Traditional: A Grand Slam of Factors to Remember.
Roth IRAs are often the best option for your savings, especially if current tax rates are low and future rates will be higher.
Maxing contributions matched by your company in your 401(k) or retirement plan? Check. Paid off high interest loans and built-up emergency cash savings to 3-6 month’s pay? Check. The next step in planning for your financial future is likely opening an Individual Retirement Account (IRA). But Traditional or Roth, which to choose? When considering between these two common IRA options, including whether to convert a Tradition IRA to a Roth IRA, it is crucial that you cover your four bases.
First, a primer. Remember that the main difference between a Roth and a Traditional is when taxes are paid. For a Roth IRA, you pay tax on your contributions, allowing the account to grow tax free. Pay tax now, enjoy your savings later. With a Traditional IRA, you take a tax deduction on contributions (depending on income level), allowing the account to grow tax deferred. But you pay tax on any money at the time of withdrawal: deduct tax now, pay later. Both types of accounts shield you from tax on annual income or realized gains within the portfolio.
When deciding between a Roth or Traditional IRA, the first, and most impacting of the factors is tax rates—specifically current rates versus future ones. This can be broken down into a relatively straightforward “if, then” formula. If current tax rates are low today and future tax rates are higher in the future, then the Roth IRA is the best option because you will pay taxes at the current, lower tax rate. Conversely, if current tax rates are higher today than they will be in the future, then the traditional retirement account is the better option.
Keep in mind where you fall in income brackets during your lifetime will affect your decision. If you’re a young worker currently paying low rates, for example, Roth IRA is likely best suited for you. If you’re nearing retirement and soon expect a drop in income (and tax rates), or expect your account to be withdrawn by heirs at their lower personal tax rates, think Traditional IRA.
Second, you need to understand the impact of RMDs (required minimum distributions) during the lifetime of the IRA owner. Roth IRAs are not subject to RMDs during the account owner’s lifetime, allowing more dollars to remain inside their tax-preferred shelter. Traditional IRAs are slowly drained as a result of RMDs, forcing money into taxable accounts where growth is slowed by ongoing taxes This benefit also makes Roth IRAs more attractive for those seeking a “Stretch IRA” strategy. Without RMDs, there will be more left in the Roth IRA for your heirs to stretch out. And if your spouse is named sole beneficiary, they can transfer the assets into their own Roth IRA, continuing to “stretch” the tax-free cycle.
Third, contribution limits and the resulting tax liability is a factor that should be considered. In order to take full advantage of the $6,000 maximum contribution limit, you need to choose a Roth IRA and pay taxes with funds outside of the account, allowing your full contribution to grow untouched. With a Traditional IRA, remember that part of all contributions are taxed from within, meaning that for someone in the 24% tax bracket a $6,000 contribution actually means they are investing $4,560 for themselves but $1,440 on the behalf of the IRS. Finally, remember that there are simple income limits for Roth IRA’s; couples earning above $208k in 2021 are not even eligible to contribute.
And to complete the bases, the fourth factor is state estate taxes. Most states that have a state-level estate tax do not have a state IRD deduction. This means that there could be a potential for savings on state-level estate taxes by converting a traditional IRA to a Roth IRA before death and having the large tax payment (at income tax rates) reduce the size of the taxable estate (at estate tax rates). Of course caution is needed to avoid increasing the tax rate up too far with a big conversion and creating a tax impact that outweighs potential estate tax savings. Check with your tax advisor and your state’s individual policy closely.
Yes, Roth IRAs have several advantages over traditional IRAs, because of the four factors above. The Roth IRA avoids lifetime RMDs, avoids state estate taxes, and allows you to truly maximize contributions if you can pay tax with outside funds. However, the most important factor is still the first one: current tax rates versus future rates. Remember the golden “if, then” formula from above, and you will be saving your way to a stress-free and tax-diminished future.