CHICAGO, August 7, 2019 – Saving for retirement is a must – knowing which option is best for you isn’t always clear. If you are unsure about whether to invest in a traditional individual retirement account (IRA) or in a Roth IRA, the Illinois CPA Society provides some details you may consider first.
The tax advantage of traditional IRAs is that your contributions are tax-deductible in the year you make them, and your investments grow tax-deferred until withdrawals or distributions begin. Anyone can open a traditional IRA, but there are contribution limits. For 2019, you may contribute a maximum of $6,000 or up to $7,000 for those 50 and older. Other key details of traditional IRAs are:
- Investments grow tax-deferred as long as they remain in the account
- Early IRA withdrawals made before age 59 ½ will be taxed as income and may be subject to a 10 percent penalty if not used for a qualified expense
- Contributions must stop and you must begin taking required minimum distributions (RMDs) at age 70 ½
- Distributions in retirement are taxed as ordinary income
In a Roth IRA, contributions are made with after-tax money, which is not tax-deductible. However, your investments in a Roth IRA grow tax-free and remain tax-free when withdrawn in retirement. The current contribution limits for Roth IRAs are the same as those listed above for traditional IRAs. The significant differences are:
- Contributions can be made at any age
- There are qualification and contribution limits based on your income
- There are no RMDs with a Roth IRA. Once you turn 59½ and have held the account for at least five years, you can take distributions and earnings from a Roth IRA without paying federal taxes on your contributions or investment earnings
- Roth IRA account holders may make early withdrawals tax-and penalty-free for qualified expenses, such as a first-time home purchase, if the five-year aging period has been met. Funds also may be used to cover qualified college expenses without an early distribution penalty
- Early withdrawals of the account’s investment earnings may trigger taxes or a 10 percent penalty if used for reasons outside of the IRS’ qualified distributions and exceptions list
So, which type of IRA may be right for you? A Roth IRA may be a smart option if you expect your tax rate or tax bracket to be higher in the future. Because Roth IRA contributions are made with after-tax money, your retirement income from Roth IRA distributions is tax-free, avoiding the impact of potentially higher future tax rates.
However, if you think your overall income will drop in retirement, that could mean that you’ll be in a lower tax bracket. In that case, the taxes you’d pay on distributions in retirement from a traditional IRA may be lower than the taxes you’d pay today to contribute to a Roth IRA.
And if you already have a traditional IRA and are thinking of converting to a Roth IRA, you may consider whether you have enough money to pay the taxes incurred during a Roth conversion. If you’ll be going into debt to cover them, or dipping into your retirement savings, the conversion may not be a financially sound step.