Factors to consider when choosing a Roth or traditional IRA

Both Roth IRAs and traditional IRAs are powerful tax-advantaged retirement savings accounts. Here are some factors to consider when choosing which one is right for you.

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Amy Chain: Okay. Christopher is asking about those who have both a Roth IRA and a traditional IRA, “If you max out, do the max-out rules apply to both or one or can you—“ Let’s talk about the balance between those two types of accounts.

Maria Bruno: I’ll start, Christine. The nature of the accounts are different, so to the extent that you have earned income, you can contribute to an IRA. The question then is whether it’s a traditional deferred IRA or a Roth IRA.

So, with a traditional deferred IRA, anyone can contribute as long as they have earned income, of course. The question is whether or not the contributions are tax deductible. And there are income phase outs there. The other is there’s a Roth IRA where you make contributions with dollars that have already been taxed so you don’t get the tax deduction in the year of contribution, but the account grows tax free. And there’s income eligibility requirements there.

So, it’s best to think about it in terms of what your long-term goal is. For many, a Roth IRA offers, you know, a lot of perks in terms of you don’t have to take required minimum distributions from Roth IRAs when you’re in retirement. Having both offers tax diversification. And what I mean by that is having different account types that are taxed differently affords flexibility and strategic decision making later in retirement when you’re going to either draw down or if you’ve got different types of goals such as legacy goals or whatnot. So, both are excellent retirement savings vehicles and should be maxed out. The question is whether it’s a traditional or a Roth IRA.

Amy Chain: Is there a rule of thumb about what you contribute to first or is there a percentage that you split between the two? How should you think about using both or either a Roth or a traditional?

Maria Bruno: I don’t think there’s a specific percentage between the both. I guess I would start with a couple things. One is, if you are someone who is covered by an employer-sponsored plan, look to the employer-sponsored plan first to see, you know, if you get a company match and if you have the option to do a Roth or a traditional deferred, you could split those contributions up, for instance. But the employer match is made to the traditional deferred account. So, if you invest in a Roth in your 401(k), for instance, if you have that option, the match goes into the traditional deferred account. You get instant tax diversification there. So that’s one way where you can be strategic.

I like the Roth IRA for those that are saving outside of the company plan because of the fact that you don’t have to take lifetime distributions and you can access the contributions income tax free or penalty free, as we just discussed, to the amount that you’ve contributed. So, there’s some flexibility there which can be beneficial for investors down the road if needed.

The one thing to think about is, as I mentioned, there are phaseouts. And someone can go to our website and actually look at, we’ve got a handy table that talks about the differences between the two types of accounts. You can do a two-step process to get into a Roth IRA if you’ve exceeded the eligibility thresholds. And by that, I mean you can make a contribution to a traditional IRA and then subsequently convert that to a Roth, so it’s a two-stepped process for contributing to a Roth IRA.

Some things to think about if you have other IRAs, other nondeductible, traditional IRAs that you’re not converting, there’s some things to think about there in terms of aggregating accounts for the purpose of calculating any tax consequences. If someone’s interested in learning more about that, I would suggest the website is a good place to get started because I think we’ve got a lot of good information there.

You can add to that. I know I talked a lot about Roth.

Christine Benz: Well, no. I have been hearing a lot about the backdoor Roth IRA maneuver since the income limits on conversions were lifted back in 2010. And this is something that only high-income people would care about. If you are below the thresholds for contributing to a Roth IRA, you can go in through the front door. You don’t need to do this backdoor maneuver.

But, as Maria said, there are some caveats to keep in mind. One is, if you’re someone with a lot of traditional IRA assets, as Maria said, and you are also opening this new little IRA that you plan to do the backdoor with, just be careful because when you do that conversion, more of it would be taxable than you might be planning on. So, get some tax help there before you undertake this maneuver. But it can be a way for high-income folks who had heretofore been shut out of Roth contributions to make them and get some money over into the Roth column.

And I would agree with Maria, too, that if your company offers both a Roth 401(k) as well as traditional 401(k) contributions and you’re not sure what to do, think about doing some splitting of contributions and kind of split the difference between the two account types.

One profile, though, that I’d like to address before we leave this question is for people who are later in their accumulation careers and have not yet amassed much in terms of retirement savings and maybe can earn a tax deduction when they make a traditional IRA contribution, they may be better off doing that because their tax rate now when they make the contribution may well be higher, and, therefore, the tax benefit of making the contribution may be better now than it is later on. So that would be a reason to look at making a traditional contribution.

Maria Bruno: That’s a good point, and then, also, to add to that would be for individuals that are young and in their early earnings phase, their tax bracket may feasibly be much lower than it would be later in retirement or postretirement.

Christine Benz: Absolutely.

Maria Bruno: So, the value of a tax deduction with a traditional deferred account is most likely outweighed by the benefit of the tax-free growth of the Roth account. So those are a couple guidelines. So, it’s not so much a percentage, but more of where you are in your investing journey and what does your tax picture look like now, your time horizon, and then your tax picture potentially later?

Christine Benz: Yes, that seems like the young accumulator. Sometimes I talk to new grads who say, “Yes, I’m starting my new job, and I’m starting an MBA program at the University of Chicago.” And I’m like, “Okay, you’re a good Roth candidate. Let’s move on because you are a young accumulator who’s likely to be in a higher tax bracket in the future than you are today.”

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