Traditional IRA or Roth IRA: Which is the Right IRA for You?
By Bill Gallagher, CFP®, MBA
More and more, Americans are taking charge of retirement and establishing savings plans to help build their retirement nest eggs. The type of individual retirement account (IRA) you choose can significantly affect you and your family’s long-term savings. So, it’s important to understand the similarities – and the differences – between Traditional IRAs and Roth IRAs in order to select the option which is best for you.
When comparing IRAs, questions often arise around the considerations relating to both contributions and distributions. In addition, many clients ask if they should consider converting their Traditional IRA to a Roth IRA. The answers to these questions can have a significant impact on one’s tax situation over the balance of their lifetime. The following can help provide a basic overview of both Traditional IRAs and Roth IRAs. In addition, we provide a brief discussion on Roth IRA conversions to help clients navigate through the nuances of the conversion process.
By now, many people are aware they can make an annual tax-deductible contribution to a Traditional IRA. (1) In 2021, an individual (regardless of age) who have earnings from employment may contribute up to $6,000 to a Traditional IRA. In addition, those who are age 50 and over are allowed to make a catch-up contribution in the amount of $1,000.(2) However, many people are surprised when their accountant tells them that they may not receive the full deduction for their contribution.
This deduction limitation is based on two factors: your modified adjusted gross income (“AGI”), and your active participation in an employer-sponsored retirement plan. (3) For example, in the case of a married couple who are both active participants in an employer-sponsored retirement plan, and whose 2021 modified AGI is greater than $125,000 ($76,000,000 for a single filer), no deduction will be allowed.
While the tax deduction may be phased out, or even eliminated for certain high-income taxpayers, it should not dissuade them from making a non-deductible, after-tax contribution to a Traditional IRA. Even though a tax deduction will not be allowed, contributions to the Traditional IRA will grow tax-deferred over the course of the individual’s life. Individuals who choose to make an after-tax contribution to a Traditional IRA will need to keep track of these non-deductible contributions (IRS Form 8606) to ensure that these contributions are not taxed again upon distribution from the Traditional IRA during retirement.
To the extent an individual has made tax-deductible contributions to a Traditional IRA, any distributions from the IRA are considered ordinary income and will be taxed accordingly in the year of the distribution. In addition to ordinary income tax, distributions prior to age 59 1⁄2 are subject to a 10% penalty.(4) However, there are certain situations in which the IRS will waive this 10% penalty. According to “IRS Publication 590-B – Distributions from Individual Retirement Accounts”, these exceptions include:
- You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income,
- The distributions aren’t more than the cost of your medical insurance due to a period of unemployment,
- You are totally and permanently disabled,
- You are the beneficiary of a deceased IRA owner,
- You are receiving distributions in the form of an annuity,
- The distributions aren’t more than your qualified higher education expenses,
- You use the distributions to buy, build, or rebuild a first home (up to $10,000),
- The distribution is due to an IRS levy of the qualified plan,
- The distribution is a qualified reservist distribution.
Because non-deductible contributions made to a Traditional IRA are treated as an investment in the contract (cost basis), when withdrawn these contributions are not considered taxable income. However, the earnings portion of the non-deductible Traditional IRA is considered ordinary income and will be taxed accordingly. In addition, if the distribution is made prior to age 59 1⁄2, a 10% penalty may apply to the portion attributable to the earnings. The calculation that determines the tax-free and taxable portions of distributions is complex when both deductible and non-deductible contributions are commingled in a Traditional IRA. Please refer to IRS Publication 590-B for more details on the tax treatment of such distributions.
Another important feature of Traditional IRAs is the Required Minimum Distribution (“RMD”). The RMD is the mandatory amount that must be distributed from a Traditional IRA on an annual basis, starting on April 1st of the year following the year in which an IRA owner attains the age of 72.(5) The amount of the RMD is based on the year-end balance of the Traditional IRA and the IRA owner’s life expectancy.
The Required Minimum Distribution will have a direct impact on the IRA account owner’s tax bracket during retirement. If the IRA owner fails to consider how the RMD will impact his or her tax bracket during retirement, they may find themselves in a higher tax bracket once distributions commence, especially if the Required Minimum Distributions are sizable. At that point, there would be little the individual could do to help alleviate the tax burden. In such cases, it may be prudent to begin withdrawing smaller amounts from the IRA before 72 with the expectation of being in a lower tax bracket.
Another strategy the IRA owner may implement today that may save some tax dollars over the course of his lifetime is referred to as a Roth conversion. Roth conversions are discussed below.
Unlike a Traditional IRA, contributions to a Roth IRA are made with after-tax dollars and are not tax-deductible.(6) For 2021, an individual (regardless of age) who have earnings from employment may contribute up to $6,000 to a Roth IRA. As we saw with Traditional IRAs, those who are 50 years of age and older may make a catch-up contribution of $1,000.
Another difference between Traditional IRAs and Roth IRAs is the fact that contributions to a Roth IRA are phased out, and eventually eliminated, based on an individual’s modified adjusted gross income. For example, in 2021 a married couple must have a modified adjusted gross income of under $198,000 ($125,000 for single filers) to make the maximum contribution to a Roth IRA.(8)
Unlike distributions from a Traditional IRA, qualified distributions from a Roth IRA are tax-free.(9) Qualified distributions are defined in the Internal Revenue Code as:
- Distributions that are made after the five-year period for which a contribution was made to a Roth IRA.
- Distribution under the following circumstances:
- Made after the date you reach age 59 1⁄2,
- Made because you are disabled,
- Made to a beneficiary of your estate after your death, or
- One that is made to a first-time homebuyer ($ 10,000-lifetime limit). (10)
However, should an individual take a non-qualified distribution, the amount allocable to earnings will be subject to ordinary income tax (and a 10% penalty if the distribution was made prior to age 59 1⁄2). It is important to note that an individual can always distribute the number of his contributions at any time on a tax-free and penalty-free basis. In fact, any distributions from a Roth IRA shall be treated as coming from annual contributions first, from conversion contributions second, and finally from earnings.(11)
Another important feature of the Roth IRA is the fact that a Roth IRA owner is not forced to take Required Minimum Distributions from his Roth IRA.(12) This feature can be extremely beneficial to the taxpayer who doesn’t need to draw on his Roth IRA assets to support his or her lifestyle expenses in retirement. In this situation, the funds within the Roth IRA continue to grow unencumbered on a tax-deferred basis over the balance of their lifetime.
Now that we understand the similarities and differences between Traditional IRAs and Roth IRAs, we can take a closer look at a strategy that could potentially lead to a more tax-efficient environment during an individual’s retirement. This strategy is referred to as a Roth conversion. A Roth conversion is the process of withdrawing funds from a Traditional IRA and depositing the proceeds into a Roth IRA. When a conversion is completed, the amount converted will need to be reported as ordinary income, in the year of conversion.(13) In a Roth conversion, the 10% penalty is waived for individuals who convert prior to age 59 1⁄2. However, if an individual who is not 59 1⁄2 uses the funds from his Traditional IRA to pay the tax liability resulting from the Roth conversion, the 10% penalty will be imposed on the amount used to pay the tax. Therefore, in most situations, a Roth conversion works well when the individual has enough money set aside in non-IRA accounts to pay the tax liability.
The first step in the Roth conversion process is to determine if the conversion makes sense for an individual given his or her unique financial situation. As mentioned earlier, it is extremely important for an individual to have a clear understanding of their current tax bracket and expected tax bracket in retirement to determine if the conversion is right for them. Once this is determined, they must then decide on the timing of the conversion. Given one’s tax situation, does it make sense to convert all the assets in his Traditional IRA in a single year, or would it be more beneficial to perform a series of annual conversions over the course of several years? The latter would allow the individual to spread out the tax liability over the course of multiple years.
One situation where a Roth conversion may have its place is during the early stages of retirement, especially in the years leading up to an individual’s age 72. It is during this time when an individual may find themselves in a lower tax bracket because they are no longer working, and are not yet required to take mandatory distributions from a Traditional IRA. This could be a great time for an individual to perform a series of partial conversions each year leading up to age 72. By implementing these conversions, and theoretically reducing the number of assets remaining in the Traditional IRA, the amount of the required minimum distributions at 72 should be lower, thus reducing the overall tax liability.
Another situation where a Roth conversion may make sense is seen in the fortunate case of an individual that does not need the assets in his Traditional IRA to support his or her lifestyle needs during retirement. In this situation, a Roth conversion may be implemented for generational planning purposes by essentially prepaying the future income tax for his heirs. While this prepayment may be thought of as a “gift”, it does not count toward one’s annual gift tax exclusion or against the taxpayer’s lifetime exemption amount. (14)
As we can see, while implementing a Roth IRA conversion may increase tax efficiency, the decision should not be taken lightly. One must have a clear understanding of their current tax bracket and expected tax bracket in retirement to make an informed decision. The decision should not be made in a vacuum, but rather, through collaboration with your tax advisor and financial planner. In this way, you can determine if a Roth conversion is right for you.
- (1) I.R.C. §219(a)
- (2) I.R.C. §219(b)(5)(B)
- (3) I.R.C. §219(g)
- (4) I.R.C. §72
- (5) I.R.C. §401(a)(9)(C)
- (6) I.R.C. §408A(c)(1)
- (7) I.R.C. §408A(c)(4)
- (8) I.R.C. §408A(c)(3)
- (9) I.R.C. §408A(d)(1)
- (10) I.R.C. §408A(d)(2)
- (11) I.R.C. 408A(d)(4)
- (12) I.R.C. §408A(c)(5)
- (13) I.R.C. §408A(d)(3)(A)
- (14) Cymbal, Kenneth & Barrett, Tom. (2016). Increasing the Odds of Making a Successful Roth IRA Conversion. Journal of Financial Service Professionals. Vol. 70(3). May 2016. Pg. 49- 63.