30 Dec Should I do a Roth or traditional IRA? I want to save more.
Q. Should I do a Roth or regular IRA? I already have a 401(k) but I want to save more next year.
A. We’re happy to see that you’re looking to save more for retirement.
The best answer to your question depends on the details of your individual circumstances, including your age, your marital status, your income, your participation in a retirement plan at work, your projected retirement income and your long-term goals.
Let’s start by reviewing some of the most important factors in choosing between a Roth IRA contribution and a contribution to a deductible traditional IRA.
With a traditional deductible IRA, you receive a tax deduction now for your contribution, and the money you invest enjoys tax-deferred growth until you take a distribution from the account, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.
At that point, you pay tax on every dollar withdrawn, he said.
But with a Roth IRA, you receive no tax deduction for your contribution today, he said. The money also enjoys tax-deferred growth and distributions are tax-free when you take them later on.
The numerous rules and requirements governing both types of IRAs, when coupled with your own individual situation, can make the choice complicated, McGovern said.
“The core of your question, though, comes down to whether you’d be better off taking a tax deduction today, at today’s known tax rates, or forgoing that deduction in favor of enjoying tax-free withdrawals tomorrow, when future tax rates could be higher or lower than they are today,” he said.
If tax rates are the same both now and in retirement, it makes no difference at all whether you make a traditional or a Roth IRA contribution, he said.
You’ll end up with the same amount of after-tax retirement savings regardless of which one you choose.
He offered several examples.
Assume Tom and Jerry are each in the 24 percent income tax bracket, both today and when they retire. Also assume that Tom and Jerry each decide to contribute $6,000 to an IRA, which is the maximum contribution for both 2019 and 2020 if you’re under age 50. Tom chooses the Roth IRA and Jerry the traditional IRA.
With his Roth IRA, Tom receives no tax deduction, so he pays 24 percent of his $6,000 today, or $1,440, and invests the remaining $4,560 ($6,000 – $1,440) for 40 years, earning an average compounded rate of return of 5%, McGovern said.
Jerry, on the other hand, takes his tax deduction today, and invests the entire $6,000 for 40 years at the same 5% return.
“After 40 years, Tom’s initial Roth IRA nest egg of $4,560 has grown sevenfold, to $32,102, all of which is tax-free,” he said. “Jerry’s traditional IRA of $6,000, meanwhile, has also grown about seven times, to $42,240. However, Jerry now owes 24 percent of that in taxes, so he pays the IRS $10,138 ($42,240 X 24%), leaving him with $32,102 — exactly the same amount that Tom has.”
Of course, many other factors come into play here, such as the fact that Jerry will have to begin taking Required Minimum Distributions (RMDs) from his traditional IRA starting at age 72 (under the just-passed SECURE Act), while Tom’s Roth IRA has no RMDs during his lifetime, McGovern said. Also important is whether the IRA may be passed on to your children or other beneficiaries in taxable or tax-free form.
But the key question, as the example makes clear, is whether your anticipated tax rate in retirement will be higher or lower than your tax rate today, McGovern said. That depends on both your anticipated taxable income in retirement versus today and on the relative tax rates.
Your state of residence also comes into play because many taxpayers migrate from high-tax states such as New Jersey to low-tax or no-tax states such as Florida in retirement, he said.
“A higher tax rate today argues for the traditional deductible IRA to maximize your tax savings and after-tax retirement income,” he said. “A higher anticipated future tax rate argues for the Roth.”
McGovern said because tax rates today are relatively low, and government budget deficits and future obligations are high, it’s often assumed that future tax rates are likely to be higher.
One way to deal with the uncertainty and to hedge your potential tax exposure is to maintain a mix of taxable and tax-free retirement accounts, McGovern said.
Another important aspect of your question is your participation in a 401(k) plan at work.
“There are no income limits for making a deductible IRA contribution if you — and your spouse, if married — are not an active participant in a retirement plan at work,” he said. “However, if you’re currently an active participant in your 401(k) plan — for example, by making salary deferrals or receiving employer contributions — your deductible IRA contribution may be phased out or eliminated altogether depending on your adjusted gross income.”
McGovern offered this example.
Say in 2020, a single taxpayer who is an active participant in a retirement plan earns $75,000 or more cannot make a deductible IRA contribution. The AGI limit is $124,000 for a married couple where both taxpayers are active participants, and $206,000 if only one spouse is an active participant.
In that situation, if your income is too high for a deductible IRA contribution, you could potentially make a nondeductible contribution to a traditional IRA and still receive the benefit of tax deferral on the earnings, he said. In that case, you should file Form 8606 with the IRS to keep track of your nondeductible contributions so that they aren’t taxed twice.
A better option may be to make a Roth IRA contribution. Your ability to make Roth IRA contributions isn’t affected by your participation in a retirement plan at work, but Roth IRAs do come with income limits, he said.
For 2020, provided your income doesn’t exceed $139,000 as a single individual or $206,000 if married filing jointly, you could make a Roth contribution even with your 401(k) plan at work.
Note also that your 401(k) plan may have a Roth contribution option, and that Roth 401(k) contributions, unlike Roth IRAs, are not subject to income limitations, he said.
“As you can see from this discussion, the rules and choices can be complex,” McGovern said. “Your tax advisor can help you to best tailor the rules, and your choice of savings vehicle, to your individual circumstances.”
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This story was originally published on Dec. 30, 2019.
NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.