There are two basic types of IRAs most Americans can choose from -- traditional or Roth. The basic difference is the tax structure of each. Traditional IRA contributions may be tax-deductible, but withdrawals are taxable, while Roth IRAs work the opposite way, with tax-free withdrawals in retirement.
In addition, there are several other differences between the two varieties of IRA that you should know about. Here are four advantages to investing in a Roth IRA, as well as two drawbacks, to help you make the best decision for your retirement savings.
Four Roth IRA advantages
1. A Roth IRA can let you "lock in" your current tax rate
The most obvious benefit to using a Roth IRA is tax-free compounding. Qualified withdrawals from a Roth IRA are 100% tax-free, no matter how much your account has grown. If you contribute a total of $100,000 to a Roth IRA over the years and your account is worth $1 million at the time you retire, you won't pay a nickel in taxes on your $900,000 profit.
This can allow you to "lock in" your current tax rate, which is an especially good benefit if you're currently in one of the lower (10% or 15%) tax brackets. If your income rises significantly between now and retirement, a Roth IRA can protect you from a higher tax rate. And there's always a possibility that federal tax rates will be significantly higher when you reach retirement age. In fact, the top federal tax bracket was 70% as recently as 1981.
2. Participation in your employer's plan has no effect on Roth eligibility
If you participate in an employer-sponsored retirement plan, such as a 401(k) or pension plan, your ability to enjoy the tax benefits of a traditional IRA are limited by your income. For example, if you're single and have an employer's retirement plan, you can only take a full traditional IRA deduction if you earn less than $62,000 in 2017. The ability to contribute to a Roth IRA is not dependent on whether you have an employer's retirement plan or not, just on overall income limits, which are significantly higher than the traditional IRA limits.
3. No maximum age to contribute
If you invest in a traditional IRA, you have to stop making contributions once you reach 70 1/2 years of age, even if you're still working and earning income. A Roth IRA has no such restriction -- for example, if you are 75 and working a part-time job, you're free to save and invest some of your income in a Roth IRA.
4. No required minimum distributions
Another age-related benefit of Roth IRA investing is that there are no required minimum distributions (RMD). With a traditional IRA, minimum distributions based on the IRA owner's life expectancy must be taken after the owner turns 70 1/2. Roth IRAs don't have any minimum distribution requirements during the account owner's lifetime, which can make a Roth IRA an excellent estate-planning tool.
Two big drawbacks
1. High-income individuals cannot contribute to a Roth
I mentioned earlier that the ability to contribute to a Roth IRA is not restricted based on participation in an employer's retirement plan, but there are overall income limits for Roth contributions. They are significantly more generous than the traditional IRA deduction limits, but they're still there. And it's also important to point out that everyone can contribute to a traditional IRA, regardless of income. It's only the ability to take a deduction that depends on how much you earn.
As an example, I mentioned that single taxpayers with access to an employer's retirement plan need to earn $62,000 or less in 2017 to be eligible for a full traditional IRA deduction. Well, someone in the same situation would need to earn less than $118,000 to make a full Roth contribution and less than $133,000 to contribute at all.
Finally, it's worth noting that there is a "backdoor" method of contributing to a Roth IRA that essentially consists of contributing to a traditional IRA and immediately converting the account to a Roth IRA.
2. No immediate tax deduction
A Roth IRA can let you avoid income taxes in retirement, but it does nothing to lower your tax bill immediately. While traditional IRA contributions may be deductible in the tax year in which they were made, Roth contributions are not. However, qualified withdrawals from a traditional IRA will count as taxable income, so it becomes a question of whether you want your tax break now or later.
Even though Roth contributions are not immediately deductible, they can still qualify for the Saver's Credit, which is a tax credit designed to help lower-income taxpayers save for retirement. If your AGI is $62,000 or less in 2017, the credit can put up to $1,000 ($2,000 for a couple) back in your pocket.
The bottom line
While a Roth IRA offers some pretty nice benefits, there are pros and cons involved with using one to save for retirement. When preparing to save and invest for retirement, be sure to consider all the benefits and drawbacks in order to determine which type of IRA is the best fit for you.
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