Deciding between a ROTH or a Traditional IRA is one of the most important money decisions you must make.
A key question you have to answer is: “Do you want to be taxed on the harvest or the seed? (Hint: If you want more bread, you’ll want to pay on the seed!)
Most investors use traditional IRAs for two key reasons: their contributions are currently tax deductible and the IRA “shelter” offers tax-deferred growth of your investments.
Since you will delay paying taxes until you take distributions sometime in the future, a tax maneuver called tax deferral, a traditional IRA is a good choice if you believe that you will be in a lower tax bracket after you retire. Your tax deductible pre-tax contribution will result in a meaningful reduction to your 2018 tax bill now, and possibly a lower tax bill later, provided you actually will be in a lower tax bracket later.
But the thing you must remember is that while you get a relatively small benefit up front (the deduction), you will pay an exponentially larger tax bill 0n the harvest (future withdrawals).
You are eligible for the contribution if you are under 70 ½ by the end of 2018 and had earnings upon which to base your contribution.
In 2020, the maximum yearly contribution is $6,000, but if you are age 50 or older at year-end your maximum contribution is $7,000, because of the catch-up provisions in the tax code. Also note that these are your combined limits for both Roth and Traditional IRAs.
When deciding between a traditional IRA or a ROTH, keep in mind that traditional IRA accounts require that you take annual Required Minimum Distributions starting by April 1 of the year after you turn age 70½. If you don’t take these mandatory distributions, each missed distribution carries a whopping 50% penalty on top of the regular tax.
If you expect to be in the same or higher tax bracket when you retire a Roth IRA may be your ticket.
While you will forfeit the tax deduction for your contribution for the current tax year, you will enjoy something far more powerful: tax-free growth. Your annual ROTH contributions are made with after-tax earnings, and because you will not get the current tax break, the tax deduction, you will forever be able to withdraw from your ROTH without owing any income tax on the growth. This means that you may be able to convert what may have been a taxable asset into a tax free asset. This is what makes the ROTH a powerful choice, and most often the right one.
In 2020, as with a traditional IRA, your maximum yearly contribution is $6,000, but if you are age 50 or older at year-end your maximum contribution is $7,000. And remember, these are your combined limits for both Roth and Traditional IRAs.
There is no age eligibility requirement with a ROTH, a super benefit for those who decide to enjoy a working retirement. Regardless of your age, as long as you are earning income you can make a ROTH contribution, but there are earnings restrictions. In 2019, contributions begin phasing out at certain levels of Modified Adjusted Gross Income: $123,000 for single and head of household, or $193,000 if married, filing jointly.
Another thumbs up for the ROTH is there are no RMDs to worry about. Traditional IRA accounts require that you take annual Required Minimum Distributions starting by April 1 of the year after you turn age 70½, but not so with a ROTH, thus completely eliminating the chance of triggering the 50% penalty.
So, which is your best choice?
Hands down, for most investors, never paying taxes on the harvest (future taxable distributions) is the logical choice over paying taxes on the seed, since ROTH accounts grow tax-free.
Converting taxable assets into a tax free income machine for life is a powerful argument, making the ROTH almost irresistible, however, everyone’s situation is different. Goals and circumstances differ from individual to individual, or couple to couple.