The world is full of great questions. Some can’t be answered: what was first, the chicken or the egg? Some were argued at immeasurable length, but finally we settled on an answer: is the Earth round or flat? Do we circle the Sun, or does the Sun circle us?
The latest debate among this generation’s great thinkers (of course I mean financial planners, naturally) is: To Roth or Not To Roth. Well – it depends. I know, I know – what a horribly vague answer. But, the truth of the matter is since the Roth IRA was implemented in 1997, it isn’t a clear cut answer for anyone.
Have no fear! I’ll do my best to explain the issue at hand.
What the heck is an IRA and who is this Roth guy, anyway?
Let’s start with discussing the basics of how both solutions work. An IRA (better known as a Traditional IRA) is an acronym meaning Individual Retirement Account. At its core, it’s a way to contribute pre-tax dollars (currently $5,500 annually if under age 50 with an additional $1,000 if 50 or over) into an investment of your choosing. The growth of that investment is tax-deferred and you receive a tax deduction. If you are over a certain income limit (say $184,000-$194,000), are filing jointly, and are not covered by an employer sponsored retirement plan, you may still contribute to an IRA. However, you’ll lose any deductibility and just receive the tax deferral on growth. Upon retirement, or at least attaining age 59 ½, you may pull your funds penalty-free from your IRA. Those funds are now counted as ordinary income and you’ll pay taxes at your effective tax rate.
A Roth IRA, essentially, is everything a Traditional IRA is not, but still shares similar phase outs and contribution limits. A Roth IRA allows for post tax contributions which grow tax free, not tax deferred. Thus, you get no current deduction for your contribution; however, all the growth on investments happen tax free (assuming you hit the appropriate holding periods and age limits). In other words, no taxes are owed when you take funds out in the future.
Why choose a Traditional IRA?
Why choose a Traditional IRA as your option, when you can only contribute the IRS limit combined? Those reasons are as follows:
- You are in a high income bracket now and assume your tax rate in the future will be much lower due to lack of employment income.
- You make over the IRS limit, thus you can only contribute to a non-deductible traditional IRA.
- You need/want more deductions for your tax return.
- You are not covered by an employer sponsored plan and make over the IRS phase out (since there is no income limit in this scenario).
- You believe your income will increase in the near future
Why choose a Roth?
Why a Roth then? Again, you’ll find those reasons below:
- You don’t believe your income bracket will change very much, or feel tax rates may increase in retirement.
- You have enough deductions and would rather tax diversify your retirement dollars.
- There are no Required Minimum Distributions on a Roth once reaching age 70 ½ and you don’t foresee withdrawing these funds at that time
- You’ll have lower taxable income in retirement for Social Security and/or Medicare reasons.
- A Roth is better for inheritance purposes and these funds are being left for children.
To Roth or Not To Roth?
The debate continues, as you can see. When determining which strategy is the right fit, those listed above are the major decision points. Much like everything in the financial world, there is no clearly defined right answer and understanding the specifics of your personal situation is essential.
That said, however, there is certainly a wrong answer – not saving enough! No financial planner ever had a client walk into their office and say, “I just have too much money. I should have saved less.”