Should you contribute to a Traditional IRA or a Roth IRA?
There are countless articles online addressing this question because it’s one of the most common questions in personal finance. I am frequently asked this question by people who want to start investing.
Normally, people do a little research online, open an account, and never think about it again. Don’t be that person!
You should understand the rules, benefits, and downsides of both types of accounts. Plus, you should make an active decision each year to contribute to a Roth IRA or Traditional IRA. Even if you made a Traditional IRA contribution last year, you may not want to contribute this year.
Answering the question of whether to contribute to a Traditional lIRA or Roth IRA is not always an easy answer. Like anything in finance, it depends on your personal circumstances.
There are critical rules to understand. In fact, some people are ineligible to contribute to a Roth IRA. If ineligible and you make a contribution, you could be subject to a 6% penalty per year for every year the contribution remains in a Roth IRA. This could cost you.
Rules like these, which I’ll explain in more detail, are very important because you could unknowingly cost yourself thousands of dollars in taxes later.
Now, let’s explore the differences between a Roth IRA and Traditional IRA to help you decide if you should make a contribution and to which type of account.
What is a Roth IRA?
Similar to a Roth 401(k) plan, a Roth IRA is an individual retirement account where you contribute after-tax money and withdrawals are tax-free after age 59 ½.
Unlike a 401(k) plan, you don’t need to have an employer sponsor the plan. Anybody can open a Roth IRA at a financial custodian, such as Charles Schwab, Fidelity, or Vanguard.
These are powerful accounts because you lock in the rate of tax you pay today, and your future growth and withdrawals are tax-free. For example, if you contribute $6,000, the maximum contribution for people age 50 in 2021, and grow the account to $100,000 by the time you are 59 ½, you can take out the entire $100,000 tax-free.
What is a Traditional IRA?
A Traditional IRA plan is an individual retirement account where you may contribute pre-tax money, and withdrawals are taxable as ordinary income in the future.
Identical to a Roth IRA, you do not need an employer to sponsor the plan. You can open an account at Charles Schwab, Fidelity, Vanguard, or other companies.
Traditional IRAs offer the possible benefit of a tax deduction today, which means you may lower the amount you pay in taxes. For example, if you contribute $6,000 in 2021, you may reduce your income by $6,000. If you are in the 22% marginal bracket, that equals a tax savings of about $1,320 ($6,000 x 22%).
Eligibility
Roth IRAs and Traditional IRAs have strict rules. Familiarize yourself with the rules to avoid making costly mistakes.
I’m often asked why these rules exist. My best answer is, “I don’t know. It’s the way the rules were written.”
The first rule to know is that you can contribute to a Traditional IRA or Roth IRA even if you contribute the maximum to your employer-sponsored plan, such as a Traditional 401(k). Contributing to an employer plan does not prevent you from making Traditional IRA or Roth IRA contributions. This means you could contribute a total of $25,500 to retirement accounts in 2021 if you contributed the maximum to your 401(k) ($19,500) and Roth IRA or Traditional IRA ($6,000).
Secondly, you must have earned income to make contributions. Your contribution is also limited by your earned income. The most common earned income is W2 income, tips, bonuses, or self-employment income. Earned income does not include income from rental properties, stocks, bonds, etc. This is unearned income.
For example, while the maximum contribution in 2021 is $6,000, if you only made $3,000, you can only make a $3,000 contribution.
Even teenagers can establish Roth IRAs, usually through a custodial Roth IRA, if they have earned income.
Roth IRA
The first thing you should know is not everybody can contribute to a Roth IRA. Roth IRAs have income limits, meaning if your income goes above a certain level, you are not allowed to contribute to a Roth IRA. In 2021, if your Modified Adjusted Gross Income (MAGI) is under $125,000 as a single filer or $198,000 as a married filing jointly, you can make the maximum contribution to a Roth IRA.
If your MAGI is between $125,000 and $140,000 as a single filer or between $198,000 and 208,000 as married filing jointly, you can make a partial contribution. You are not eligible to contribute to a Roth IRA if your MAGI is above these amounts.
Let me repeat – if your MAGI is $140,000 or larger as a single filer or $208,000 or larger as married filing jointly, you are not eligible to make a Roth IRA contribution.
Will the custodian stop you? No.
But, if you are audited and the IRS determines you were not eligible to make contributions, the excess contribution is subject to a 6% tax penalty for each year the excess contribution remains in the Roth IRA. For example, if you made a $6,000 excess contribution, you would owe $360. This penalty would continue each and every year that the excess contribution remains in the account.
What if you made a contribution in early 2021, received a bonus, and then determined you made too much to qualify for a Roth IRA contribution?
You have a few options. You can request your custodian designate the deposit as a Traditional IRA contribution or remove the contribution. There are certain rules and tax forms you need to complete if this happens. If so, I recommend talking with an accountant to ensure you complete all the required reporting.
If you choose to remove the contribution, you can avoid the 6% penalty by removing it before your tax filing deadline. If you remove it, you need to declare the earnings on your tax return. The custodian will normally calculate the earnings for you.
For example, if you contributed $6,000 and removed $7,000 because the account went up in value, you need to report the $1,000 earnings as income.
If you are under age 59 ½, you also pay an additional 10% early withdrawal penalty on the earnings. Assuming you are in the 22% tax bracket, this means you would owe approximately $100 as a tax penalty and $220 in ordinary income, or $320 total.
The tax penalties and reporting are why it is really important to understand if you are eligible to make a Roth contribution in advance. TIAA has a helpful calculator. You input your filing status, age, whether you are eligible for an employer-sponsored plan, and your MAGI. Then, it tells you how much you can contribute to a Roth IRA or Traditional IRA.
Traditional IRA
Anyone can contribute to a Traditional IRA. There are no income limits to worry about.
However, if you want to take a tax deduction, there are income limits. This is complicated by the fact that it depends on whether you have access to an employer-sponsored plan.
The IRS provides a good table explaining when your contribution is deductible if you are covered by a retirement plan at work.
Here is the table if you are not covered by a retirement plan at work.
If you have access to an employer plan, single filers can deduct their contribution if their MAGI is $66,000 or less in 2021. The ability to deduct the contribution completely goes away at $76,000 and higher. For married filing jointly with a MAGI of $105,000 and less, contributions are deductible and above $125,000, they are no longer deductible. In between the prior amounts, there is a partial deduction.
As you’ll see, if you are not covered by a retirement plan at work, you can have a higher income and still qualify for a tax deduction. For example, in 2021, single filers and married filing jointly without access to a retirement plan at work can always deduct their contribution, regardless of their MAGI.
Is a Roth IRA or Traditional IRA best for you?
In most cases, if you qualify for a Roth contribution, it’s usually best to contribute. There are a few reasons for it.
- Earnings and withdrawals can compound tax-free for your lifetime
- Tax rates are historically low
- No mandatory withdrawals like an IRA
- You start the clock for the five-year rule
- You can withdraw your contributions without tax or penalties at any time
- You likely will contribute more instead of spending
Roth IRAs are powerful tools for tax-free withdrawals. Once you are over age 59 ½ and you’ve had the account for more than five years, every single dollar is yours. The government does not receive a cent from your withdrawals. What you see is what you get. For someone in their 20s or 30s, tax-free compounding over many decades is helpful.
If you contributed $6,000 for 30 years and earned 7% per year, you would have over $560,000 available to you entirely tax-free. And, you only needed to contribute $180,000.
The other thing to keep in mind is tax rates are historically low. Even if you could receive a tax deduction for your IRA contribution, it may not be worth very much if you are in a higher tax bracket when you are taking withdrawals. It’s impossible to say what tax rates will look like in the future, but a Roth IRA is a way to lock in your tax rate today.
Roth IRAs also do not have mandatory withdrawals. Traditional IRAs do. At age 72, you are required by law to withdraw money from a Traditional IRA. These withdrawals are known as required minimum distributions or RMDs. After a career of deferring taxes, the IRS wants their tax revenue. This means your tax deferral won’t last forever.
By opening a Roth IRA early, you are starting the clock on the five-year rule. The five-year rule says that in order to withdraw earnings from your Roth without taxes, the account has to be open for at least five years and you need to be over age 59 ½. The five-year clock starts with your first contribution, which means even if you have $100 today, you may want to start the Roth IRA to start the clock. There are a few exceptions to this rule, such as withdrawals for a first-time home purchase up to a $10,000 lifetime maximum, qualified education expenses, disability, and a few others.
Roth IRAs also allow you to withdraw your contributions any time, for any reason. For example, if you contributed $30,000 over ten years and the Roth IRA grew to $70,000, you could withdraw the $30,000 and pay no taxes or penalties. It’s a more flexible type of account because, with a Traditional IRA, you would owe taxes and penalties if under age 59 ½.
The last major reason to contribute to a Roth IRA over a Traditional IRA is that you likely will save and accumulate more money. For example, if you make a $6,000 Roth IRA contribution, the entire $6,000 plus earnings will be yours. The same cannot be said for a Traditional IRA. For a traditional IRA, you will pay tax on the contribution and earnings, but you are only able to contribute the same $6,000.
If you fast forward 30 years and you have the same $100,000 in a Roth IRA and Traditional IRA, you can spend the full $100,000 if you withdraw it from the Roth IRA. If you tried withdrawing the $100,000 from the Traditional IRA, you may only be able to spend $80,000 of it and $20,000 may go to taxes. I am using random ending numbers and tax amounts to illustrate the point – each situation will be different. The key point is the withdrawal from the Traditional IRA will be less than 100% of your money after accounting for taxes.
To help equalize the amount you can spend in the future, you should invest your tax savings from the Traditional IRA contribution.
For instance, if you saved 22% or $1,320 in taxes by making a Traditional IRA contribution, you should invest the $1,320. If you don’t, you are spending your tax savings today and cheating yourself out of more in the future. The Roth IRA is one way to force yourself to save more.
Most people say you need to compare your tax bracket today versus the future. If you expect to be in a higher tax bracket in the future, the Roth IRA makes more sense because you pay your tax at a lower rate today and take withdrawals tax-free later.
The opposite is true if you expect to be in a lower tax bracket in the future. If that is the case, you want to take a tax deduction today at a higher rate and pay taxes on your withdrawals at a lower rate in the future.
The problem with this line of thinking is if you have 20-30 years before you start withdrawals, it’s really tough to say if you will be in a lower or higher tax bracket.
Instead, I generally suggest making a Roth IRA contribution for as long as you are eligible. There are a few exceptions to this rule, such as if you are trying to minimize your student loan payments for the public student loan forgiveness (PSLF) program. There are other exceptions, but this is a reminder to research your own situation before deciding which type of contribution to make.
Please note you can only contribute $6,000 total to a Traditional IRA or Roth IRA per year. You can’t contribute $6,000 to a Traditional IRA and then contribute $6,000 to a Roth IRA. The total contribution amount between both accounts is $6,000.
If you want, you can split the contributions. For example, you could contribute $2,000 to a Traditional IRA and $4,000 to a Roth IRA. I don’t generally recommend splitting contributions between a Roth IRA and Traditional IRA because it is harder to track, and there is more room for error; however, I am a fan of splitting contributions between a Traditional 401(k) and Roth 401(k).
Lastly, you can make Traditional IRA and Roth contributions until your tax filing deadline, not including extensions. This means if you want to make a contribution for 2021, you have until April 15, 2022, to make the contribution. Since you should already know your income by that point, you can make a more active decision about whether to make a Traditional IRA or Roth contribution. This is different from a Traditional 401(k) or Roth 401(k), where you can only make contributions in the calendar year.
Summary – Final Thoughts
Deciding whether to make a Traditional IRA or Roth contribution is highly dependent on your personal circumstances. Generally, most people are well served by making Roth contributions as long as they meet the income requirements and don’t go over the income phaseout limits.
There are a few situations Traditional IRA contributions make more sense, but the tax deduction is usually limited, making the Roth IRA more attractive in most situations.
Either way, please review the rules, income limits, and benefits in detail before taking action.
I wish you the best in deciding which makes the most sense for you.
If you found this helpful, please share it with a friend. I find most people have this question and could benefit from thinking more about their retirement savings.