What is a better fit for you as an investor: A traditional IRA or a Roth IRA? Whether you’re a financial planning Do-It-Yourselfer or you’re working with a financial advisor, it’s important to understand the IRA advantages and disadvantages in both situations.
Both Roth IRAs and traditional IRAs can be great investments for retirement if, of course, you qualify to contribute to them. Both have interesting features that can make them very advantageous. To know which is best for your situation, you must understand the differences. Here are a few:
IRA advantages and disadvantages
- For 2018, the annual contribution limit for a Roth and traditional IRA is $5,500 ($6,500 if you’re over age 50), and you have the freedom to invest in any type of investment you are comfortable with (stocks, mutual funds, ETFs, bonds, CDs, annuities, etc.). Please note that this is a combined contribution limit, so you can’t invest $5,500 in both types of IRAs for the same year – only $5,500 total annually between both types of IRAs.
- Your money grows tax-free in a Roth IRA, however, contributions are not tax-deductible like they are with a traditional IRA, so no matter what your tax bracket is in retirement (past age 59-½), your distributions will be free from taxation.
- You can make non-deductible contributions to a traditional IRA, and those contributions should never be taxed once withdrawn (you must keep track of non-deductible contributions carefully).
- Roth IRA rules allow you to withdraw your contributions at any time without penalty or tax implications, but please note: This applies only to contributions; not earnings. Those earnings would be taxed and then penalized 10 percent for early withdrawal if you are under age 59-½; traditional IRAs do not allow for this.
- Traditional IRA rules allow you to withdraw your money early (before age 59-½) at any time, but there is a 10 percent penalty for doing so. There are also several exceptions where the IRS will waive the 10 percent early withdrawal penalty.
- You never need to take money out of a Roth IRA if you don’t need to, unlike a traditional IRA, where at age 70-½, you must start taking annual Required Minimum Distributions (RMDs).
- You can contribute to a Roth IRA after age 70-½ if you still have earned income. (You cannot contribute to a traditional IRA once you reach age 70-½.)
- You can pass a Roth IRA onto your heirs without any taxes or penalties, making it a very effective estate planning tool.
- If your Adjusted Gross Income (AGI) is too high, your Roth IRA contributions are either phased out or you cannot contribute to a Roth IRA.
- If you are already covered by a retirement plan at work – and depending on your tax-filing status and your income – your traditional IRA contributions may not be tax-deductible, or only partially deductible.
- Even if you can’t contribute to a Roth IRA because of the earned income limitations, there are no longer any limits on who can convert a traditional IRA to a Roth IRA (also known as a “backdoor Roth IRA”).
- There is no guarantee that the IRS and/or the U.S. government won’t change the tax status of Roth IRA earnings in the future (the possibility of being taxed could always happen). For example, Roth IRA recharacterizations have gone away with the new 2018 tax laws.
- You need to have a crystal ball to determine whether tax rates will be higher, lower or the same as in the future when you retire, which will determine the true effectiveness of Roth IRA compounding investments vs. traditional IRA compounding investments over time (read this last point as “it isn’t easy to figure this out”).
So, which IRA is best for you? Depending on your specific situation, you could contribute to both, either or neither type, but be sure to know the rules so you choose the right option. It’s your retirement money after all!
If you are a Do-It-Yourselfer and are planning your retirement on your own, I encourage you to look into the IRA advantages and disadvantages in both situations.
If you’re not working with a financial advisor but want to, make sure you find an experienced financial advisor who deals with traditional and Roth IRAs on a regular basis, works for a RIA firm, earns his or her money from fees (not commissions), believes in having an abundance of investment choices for clients and has the heart and demeanor of a teacher; not a salesperson. If you found an advisor who fits all of the above criteria, chances are you’ve found the right financial advisor to help you prepare and plan for your retirement.
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