Placing your hard-earned savings into an investment vehicle like an IRA can feel like an achievement, but how do you know which one to choose? And does it really matter? Yes! It does matter and here's why.
Given the financial pressures most Americans face, putting savings in any long-term investment vehicle can feel like an achievement. By the time you’ve found a financial professional, combed through your financial history, and thought through your plans for the future, you may feel confident that saving for retirement using an IRA can help you live out your later-life dreams.
Other pieces, though, may be less clear. For example, should you pick a traditional IRA or a Roth – or both? Does it really matter?
Yes! It really matters. To understand why, let’s explore some similarities and differences between the two.
Traditional vs. Roth: Key Similarities:
- Both are long-term savings and investment vehicles. While this may sound similar to a 401(k), it is important to understand that IRAs and 401(k)s are not the same. A 401(k) is a type of employer sponsored retirement account, whereas IRAs – both traditional and Roth – are individual retirement accounts.
- Both offer tax advantages.
Traditional vs. Roth: Key Differences:
- They offer different kinds of tax advantages. Traditional IRAs provide an upfront tax deduction, meaning that you contribute to your IRA from pretax income and then pay taxes on it later, when you withdraw during retirement. Roth IRAs require you to pay taxes on contributions upfront.
- They differ on income limits. No matter how much money you earn, you can contribute to a traditional IRA. A Roth IRA has income limits. For the year of 2020, for example, individuals filing as single needed to have a Modified Adjusted Gross Income (MAGI) under $139,000, with contributions being phased out starting at a MAGI of $124,0001. However, deductibility may be phased out or eliminated depending on income for traditional IRA contributions.
What’s Right for You?
To create a sound plan around any vehicle with tax considerations, we recommend that you discuss your options with a financial professional. One of the key points to consider in this conversation might be your current income compared to what you think your income will be in retirement. Depending on when you think your tax rates will be higher, you may want to emphasize investment in one vehicle over another.
Your conversation with a financial professional may also help you realize that you’re less interested in choosing between a Roth and a traditional and more interested in strategically combining them. You can mix traditional IRAs, Roth IRAs, conversions, and Social Security to create a tax-effective retirement strategy that helps stretch your nest egg further.
For example, Roth distributions don’t count as gross income when the IRS determines Social Security benefits taxation. This means that consumers can benefit by drawing from two buckets – the Roth and the traditional IRA – to realize significant tax savings.
Alternatively, you could split the income deficit between the traditional and Roth accounts from the start. Not only can the Roth income keep your tax bracket and benefits taxation low throughout retirement, but drawing down tax-deferred accounts can reduce RMD taxes (and others) later on.
Combining Roth and traditional distributions can make it easier to delay taking Social Security until you turn 70. The savings in both buckets could enable you to live on distributions early in retirement, paying taxes on half of your income or less. When you do collect, however, you’d have a substantially higher benefit2, which would let you draw less from both accounts, further reducing your taxes while helping to protect against the risk of outliving your money.
As noted earlier, make sure to discuss these options with a financial services professional to figure out which one is right for you.