Understanding the difference between Roth and Traditional IRAs can be confusing, but it is critical for retirement planning. In this article, we will discuss the difference between both types of IRAs and which may be best suited for you. We will also consider the process of converting a Traditional IRA to a Roth IRA and why this financial strategy may make sense for you.
A Traditional IRA allows you to reduce your taxable income when you make a deposit to your IRA by the original due date of your tax return. The amount you deposit in your IRA account is then treated as a reduction to your total income on your tax return. For those in the 25% tax bracket, this means that a deposit of $5,000 is only $3,750 out of pocket since you are getting a tax benefit.
If you have a 401(k) or similar retirement plan at work, your ability to deduct you IRA deposit may be limited depending on your income. This phase-out begins at $77,000 for singles and $123,000 for taxpayers that are married filing jointly. On the withdrawal side, you may not withdraw funds prior to 591/2 (with limited exceptions). Beginning in the year 2023, you are required to start taking required minimum distributions (RMDs) at age 73.
The withdrawals are taxed as regular income and subject to whatever marginal rate you’re in when you withdraw the money. The benefit of this is that many people expect to be in a lower tax bracket upon retiring than when they were working. Since you received an adjustment lowering your total income when you made the contribution, you will report any distributions from a traditional IRA as taxable income.
Now, let’s look at the Roth IRA. In a sense, it’s the opposite of the Traditional IRA. You do not receive a tax deduction for deposits. However, the money can grow tax-free. Once you have held the Roth IRA for 5 years and reach 59 ½ years old, the money you deposit can be withdrawn at any time without penalty, and any growth within the account is not taxable. There are no required distributions at any age. The Roth IRA has its own income limits if you are covered by a plan at work; the phase-out begins at $146,000 for single taxpayers and $230,000 for married filing jointly.
Finally, you have the option to convert money from your Traditional IRA to your Roth IRA. In order to do this, you would be required to pay the tax on the converted amount. However, once that moneyis part of the Roth IRA, it would not be subject to tax again. Any conversions from a traditional IRA to a Roth IRA must be done within 60 days to be considered a conversion contribution. The current law also permits a conversion from your 401(k) directly to a Roth account.
Now that you know the basics, how do you decide which one is right for you and whether or not a conversion from your Traditional IRA or 401(k) to a Roth IRA is the right move?
First, you must know your marginal tax rate which is the tax paid as a percent of the very next dollar of taxable income. Unless you are near retirement or already there, your marginal rate at retirement is a bit of a long term forecast. Keep in mind, however, in today’s dollars, a single retiree over the age of 65 can have $63,550 in gross income (with the standard deduction totaling $16,550 this is $47,000 taxable) to be at the top of the 12% bracket.As a first step, it’s not a bad idea for someone in the 10% or 12% bracket to choose Roth knowing that as their income increases, they may wish to move to the pre tax 401(k) or IRA to avoid taxation at a higher tax rate.
An older wage earner may find that their pension will provide a higher replacement income, and when combined with their own retirement account withdrawals, they will be in a higher tax bracket at retirement. Using Roth IRAs and starting to convert their pre-tax accounts can be a good idea to help keep your overall tax rate in check. If you decide to convert, remember, it’s wise to do this only if you can pay the tax, when due, from other funds, and not from the IRA money.
As with any financial issue, your specific situation will differ from those of others, so it is important to understand the tax consequences of any decision you make.
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