Part of the job as a Financial Planner is providing investment advice. We believe it’s important to educate clients so they can have a true understanding of the reasoning behind our strategies and decisions. Not everyone has a financial background (or the time/desire to learn about it on their own), so this often means getting back to the basics. What might be “common sense” to one person, might be brand new information to another. We have turned some of the questions we encounter most often into a Q&A series, starting with Part 1:
Q: What’s the Difference Between a Traditional IRA and a Roth IRA?
A: Traditional IRA contributions are pre-tax — which means (assuming you qualify – more on that later) you get to take a deduction on your taxes TODAY in order to decrease your taxable income. If your taxable income is $55k and you make a $5k contribution to your IRA – your taxable income is now $50k. Traditional IRAs are also “tax deferred” accounts which means you will not pay tax on any growth in value until you eventually begin making withdrawals from the account. Withdrawals made PRIOR to retirement age (59 ½) typically incur early-withdrawal penalties, and withdrawals made at/after retirement are taxed at ordinary income rates. Traditional IRAs also require you to start taking Required Minimum Distributions (RMD’s) at age 70 ½ (whether you want to or not).
Roth IRA contributions are post/after-tax — which means you do NOT get to take a deduction on your taxes TODAY. If your taxable income is $55k and you make a $5k contribution to your Roth IRA – your taxable income is still $55k. This is why it’s called an “after-tax” contribution – you’ve already paid tax on those dollars at today’s rates. As the account grows, like the Traditional IRA, no taxes are incurred. So, why would I choose to do this and forgo the tax deduction today? Because your withdrawals are TAX-FREE in retirement. And there are no RMDs with Roth IRAs. Further, contributions made to a Roth IRA can be withdrawn at any time (however, five years must have passed since the first contribution before you can remove any investment earnings without penalty).
Q: So Which IRA is Better for Me?
A: The answer to this question will vary from person to person. Do you want to pay taxes NOW (Roth IRA) or in the FUTURE (Traditional IRA)? Of course, no one can predict future taxes, but we can do our best to estimate.
If you’re married and making $50k today — and you’ll make $450k+ down the road — you’d probably rather pay taxes TODAY at 12% (Roth) than in the future at 35-37% (Traditional).
Keep in mind, though, that if you’re going for Public Service Loan Forgiveness (PSLF) – there are factors beyond just current vs. future tax rates that you’ll want to consider.
Q: Who Can Contribute to an IRA?
A: Traditional IRA: anyone who has earned income (or via a spousal IRA) can make a contribution. But whether or not you can DEDUCT that contribution is a different question (we will save the topic of Non-Deductible IRAs for another day). There are annual income limitations depending on your tax filing status, access to a workplace retirement plan, etc. These limits change annually – you can see the IRS figures for 2019 here.
Roth IRA: similar to the traditional IRA, you must have earned income in order to contribute. There are different annual income limitations for Roth IRAs which can be found here. If you are over the income limits for Roth IRA, there is a “back-door” funding option to consider.
Q: How Much Can I Contribute to My Retirement Plan?
A: The annual maximum limits vary between plan types and are typically adjusted for inflation each year. The below figures are for 2019. Keep in mind that the ability to fund a plan to these stated limits vary based on circumstances.
- Traditional IRA: $6,000 (plus a $1,000 “catch up” if you’re 50+)
- Roth IRA: $6,000 (plus a $1,000 catch up if you’re 50+)
- 401k, 403b, 457, TSP (Employee Max): $19,000 (plus a $6,000 catch up if you’re 50+)
- Solo 401k (Self-employed): $56,000 (plus a $6,000 catch up if you’re 50+)
- SEP IRA: $56,000
- Simple IRA: $13,000 (plus a $3,000 catch up if you’re 50+)
Q: What is the Difference between an IRA and a 401k?
A: Both 401k plans and IRAs allow you to save for retirement – pre or post tax – but there are notable differences between the two:
- Allowable contributions are higher than an IRA (see contribution limits above)
- Often have an employer match to incentivize saving
- Eligibility is not limited by income
- Generally protected by ERISA (from creditors – with some exceptions)
- Limited investment selection & opportunities for proper diversification & allocation
- Potential for expensive funds & high administrative fees
- Lack of control over 401k plan
- RMD’s start at 70 ½ (not always a “con”, but lack of choice in matter can be)
- Greater options for finding lower-cost funds & avoiding unnecessary fees
- Larger investment selection
- More control over plan – self-directed
- There are no RMD’s with a Roth IRA
- Lower allowable annual contributions than a 401k
- No employer matching
- Eligibility limited by income
- Creditor protection is more limited than with ERISA plans
Well — those are the basics for today. If you learned something new, great! If what you learned was that you don’t want to have to mess with any of this, give us a call! We’d love to help. And stay tuned for Q&A Part 2 where we get a little more complicated. Please comment with any questions or topics you’d like us to include in the next post!