Millions of people have access to a 401(k) or similar retirement plan at work, and others are not so fortunate. In either case, it's a good idea to save for retirement on your own, and for most people this means an IRA. There are two main varieties -- traditional and Roth -- so here are some questions to ask yourself that can make the decision easier.
1. When do you want to pay taxes?
Nobody wants to pay taxes, but when it comes to your retirement savings, you at least get to choose when you pay them. This is the biggest difference between the two main types of IRAs. With a traditional IRA, you may be able to qualify for a tax deduction in the amount of your contributions. However, when you eventually withdraw the money in retirement, it will be taxable as ordinary income.
On the other hand, Roth IRA contributions aren't deductible on your current tax return, but your withdrawals after you retire will be 100% tax-free. So, the first question to ask yourself is when you'd prefer to get your tax break -- now or later?
2. Will you need the money right away in retirement?
With pre-tax retirement plans like a traditional IRA or most employer-sponsored retirement plans, you are required to begin taking distributions after age 70-1/2. Once you reach this age, you'll have to withdraw a certain percentage of your account's value each year, based on life expectancy tables from the IRS.
A Roth IRA has no such requirement. You can leave the money in the account alone for as long as you want. If you don't need to use it until you're 75, 80, or even 90, that's fine. For this reason, Roth IRAs are widely considered to be the best option for estate planning.
3. Do you want early access to the money?
With either type of IRA, making an "unqualified" withdrawal will get you a 10% penalty from the IRS. There are certain exceptions to this rule, such as the ability to use IRA funds for college expenses without penalty at any time.
In addition, Roth IRAs allow you to withdraw your original contributions, but not any investment profits, for any time and for any reason. For example, if you've contributed $50,000 to a Roth IRA over the years, and your account is now worth $150,000, you can withdraw that original $50,000 whenever you want.
Because of this, a Roth IRA can effectively serve a dual purpose as a retirement account and an emergency fund. On the other hand, if you don't trust yourself and don't want the ability to withdraw your money early, a traditional IRA might be the better option.
4. Do you want to be able to contribute, even after you retire?
We already mentioned that Roth IRAs have no required minimum distributions. Similarly, they don't have an upper age limit for contributions -- or a lower one for that matter. You can contribute to a Roth IRA as long as you have earned income, no matter how old you get.
With both account types, there is no lower age limit, as long as the earned income requirement is met. For instance, if you have a 14-year-old child who just got their first job, they can contribute to an IRA, or you can do so on their behalf.
5. Do you plan to leave some of your retirement savings to heirs?
Because you can contribute your entire life and don't have any mandatory withdrawal requirements, Roth IRAs are excellent tools for estate planning. Since you've already paid taxes on your contributions, the money in your account can be left to your heirs tax-free.
One thing to note: heirs do have distribution requirements -- they can't just let the account grow forever. They'll have to take distributions from the account based on their life expectancy.
6. How much do you make?
If your AGI is more than $117,000 (single) or $184,000 (married), your ability to directly contribute to a Roth IRA is reduced, and it disappears completely above $132,000 and $194,000, respectively.
There is a "backdoor" method for contributing, which essentially means contributing to a traditional IRA and immediately converting the account to a Roth. However, if you intend to contribute to your retirement account on an ongoing basis, you may find that this is too much trouble.
7. Do you have an old 401(k) to roll over?
If you're rolling over an old 401(k), you have the option to roll it into a traditional IRA, or to convert it to a Roth. However, before choosing to convert, be aware of the tax implications. Specifically, if you convert, you'll have to pay taxes on all of the money in the account you're rolling over. Theoretically, it will all balance out in the end since your eventual withdrawals will be tax-free, but this is still something to consider.
8. Are you self-employed?
Finally, if any of your income comes from self-employment -- you get a 1099 at the end of the year instead of a W-2, or your file a Schedule C with your tax return -- you have several other options. Self-employed retirement options are expanded to include the SIMPLE IRA, SEP-IRA, and Solo 401(k). All three have significantly higher contribution limits than traditional and Roth IRAs, and are certainly looking into if you qualify.
The bottom line on IRAs
These are some of the biggest considerations when deciding which IRA is the best place for your retirement savings, but there is no best option for everyone -- it all depends on which features appeal to you most. For example, if saving money on your 2016 taxes is the most appealing thing on this list, choose a traditional IRA. On the other hand, if you'd rather have penalty-free access to your contributions before retirement age, a Roth might be better. It depends on you and your preferences.
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