Starting a retirement account or IRA is a great way to start thinking about your future. Essentially, IRAs allow for tax-efficient investing when it comes to retirement planning, but IRA holders should understand how these two options differ. Here, we take a look at the two main types of IRAs, Roth and Traditional, and the differences between them.
The key difference between a Roth IRA and a Traditional IRA is that money contributed to a Roth IRA is taxed at the time of contribution and money contributed to a Traditional IRA is taxed at the time of distribution. When a distribution is taken down the road from a Roth IRA, it won’t be taxed. In addition, the rules regarding Roth IRAs disallow people with higher incomes to contribute to them. Typically, Roth IRAs benefit people the longer they are held.
Traditional IRAs on the other hand, provide a deduction to income when one contributes to them. This means that when you contribute to your IRA, the amount you contribute can be deducted from your taxable income, creating a tax advantage. The gains and income in a Traditional IRA are not taxed while in the IRA. Traditional IRA holders only pay income taxes on the amount distributed down the road.
Say for example, you are a married individual filing jointly and your adjusted gross income is over $206,000 for 2020. According to the contribution limits for 2023 (see chart below) you wouldn’t be able to contribute to a Roth IRA. For a single person, however, this threshold would be $139,000.
The following table illustrates the 2023 contribution limits based on your filing status, modified adjusted gross income (MAGI) and explains how much you may contribute based on your age and MAGI for Roth IRAs:
Usually your contributions to a Traditional IRA are deductible against your income so you have a tax advantage. However, there are certain scenarios where your contribution may not be eligible for the deduction:
Additionally, you can’t deduct your Traditional IRA contributions if you are one of the lucky few who works for an employer that provides a pension program, like many local, state, and federal governmental organizations. In this case, you can still contribute, but it’s not going to give you a current-year deduction against your income. If any of these scenarios apply to you, it might make sense to contribute to a Roth IRA if you are eligible.
Another major difference between these two types of IRAs is that with a Roth IRA, there are no required minimum distributions at age 72 years (and older) like there are for Traditional IRAs. There are some changes to the age limitations on required minimum distributions that came out with the SECURE Act, so it’s important to stay on top of those rule changes.
Anybody can convert all, or a portion, of a Traditional IRA to a Roth IRA. There are currently no income phaseouts. However, you must pay the income taxes on the converted amount when you make the conversion. After the required holding period of 5 years from the establishment of your first Roth IRA, you can take distributions without paying any taxes.
It’s important to note that even if you have had a Roth IRA for at least 5 years, you still don’t get the benefits of your new-found Roth status for converted cash and assets for the first 24 months of that particular conversion.
Let’s look at the example of a Traditional IRA owner who converts his or her IRA to a Roth IRA and invests it for 15 years, earning 10% interest.
At the end of the 15 years, the IRA owner has $41,772 in his/her Roth IRA. This amount can be distributed without paying any income tax. The IRA owner did, however, pay $2,200 in income taxes previously.
The question is, what would the Traditional IRA have been worth today had it not been converted to a Roth IRA? Let’s compare based on the following assumptions:
It turns out that the Traditional IRA would also be worth $41,772. However, $9,189 in income taxes would be due when it comes time to take a distribution. So we are comparing paying $2,200 15 years ago, to paying $9,189 today.
For those who like to do their own calculations, it’s important to consider doing an opportunity cost analysis. This would require you to consider what you could do with the money used to pay taxes on a Roth conversion.
One of the biggest takeaways from this example is that a Roth IRA conversion has a more significant impact when the time period is longer. It also matters whether a person’s income tax rate is lower when they first contribute, opposed to when they retire. If an investor’s tax rate is higher, however, at the time of conversion compared to when they retire, with everything else staying the same, it is likely that the investor would have been better off not doing a Roth IRA conversion.
The fact is, that as you go about trying to determine which type of IRA is best for you, there is a little bit of a guessing game on what your income level is going to be down the road. There is also some guesswork as to the direction of income tax rates in your bracket when you are taking taxable distributions from a Traditional IRA.
Oftentimes, when people pay their taxes on a Roth IRA conversion, it is a little like making an investment. It might be the case that someone’s Roth IRA became more valuable than their Traditional IRA because they have to pay taxes on the conversion. For this reason, a smaller balance in a Roth IRA could actually be more valuable than a larger balance in a Traditional IRA to the IRA holder.
When deciding between a Roth and Traditional IRA, and whether or not to do a Roth IRA conversion, there is no right or wrong. As it is impossible to pin down every variable, sometimes the decision of whether or not to make the Roth conversion may involve some guesswork on the IRA holder’s part. Having some solid predictions of what your financial situation is going to be down the road, as well as your personal risk tolerance, may help you with this decision. It might also make sense to sit down with a professional and model out what the best course of action is for you.
Learn more about how you can take retirement planning to the next level with a Yieldstreet IRA.
Please note that the numbers used here are for illustrative purposes only. Yieldstreet cannot provide tax advice, so please consult a tax professional for advice specific to your situation.
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