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Traditional vs. Roth IRA

Feb 01, 2019

As fellow U.S taxpayers, deciding on where to put your money today can have long term implications when it comes to taxes. Depending on your situation, a ROTH or a Traditional IRA may be appropriate. The objective of this article is to help explain the differences.

Anyone with earned income, who is younger than 70 ½, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions: In 2019, the schedule for married taxpayers filing jointly is $193,000 – $203,000; for Single and Head of Household filers, it's $122,000 – $137,000. Individuals with incomes above the top number in each category cannot contribute to a Roth IRA, directly.

Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with traditional IRAs, you delay taxes when you put the money in. With Roth IRAs, you can avoid taxes when you take it out in retirement.

Which is better? It depends; if you expect your income to be higher in retirement, then a Roth IRA may be the way to go. Also, some economists predict, given today’s historically low federal tax rates and a large U.S. deficit, that tax rates will rise in the future – making the Roth IRA more appealing.

What if I’m earning too much and can’t contribute to a Roth IRA?

The current tax code allows high income earners to possibly fund a Roth IRA using a “backdoor IRA” strategy. I know you’re probably thinking “backdoor” sounds like you’re doing something illegal but the in the recent tax bill this was recognized as a legitimate strategy. I wish that term was never popularized but here’s how it generally works:

  • Open a traditional IRA – talk to someone independent who can help explain which companies have good investment options but without outrageous fees.
  • Fully fund your traditional IRA with a nondeductible contribution. The money is coming from your paycheck, so most likely it’s already been taxed.
  • The contribution limits for 2019 are $6,000 for anyone under 50 and $7,000 for anyone over 60.
  • Convert the traditional IRA contribution to a Roth IRA. Because the income limit does not apply for conversions (only contributions) the income limitation is in effect derailed.
  • One caveat to this strategy is if you already have an existing traditional, SEP or SIMPLE IRA funded with pre-tax/deductible contributions you may have additional tax burdens when converting to a ROTH IRA.
  • If you complete this strategy be sure to consult with your CPA to notify them. Generally, they will have you fill out a form titled 8606 so that the IRS knows this is a non-taxable event.

This is not a recommendation that you use this strategy, this is simply an explanation of how it usually works. Talk to your tax or legal advisors to determine if this would be an appropriate strategy for your tax/legal situation.

In summary, if all of your retirement money is tied up in your 401k or traditional IRA, make sure you are factoring in tax diversification when it comes to your retirement savings. If you need a hypothetical $150,000 annually in retirement to sustain your lifestyle and you pull that out of a 401k or Traditional IRA – you will pay ordinary income taxes – so you’ll need to pull out much more than $150,000. If you pull out $75,000 from your 401k and $75,000 from a Roth IRA – you’ve effectively cut your income in half, because the Roth IRA money can be accessed tax free – making your taxable income only $75,000. Diversification is not only important when it comes to investing, but just as important when it comes to retirement tax preparation.

Written by Tanner Fedell, Financial Advisor



Contact Tanner

Tanner R. Fedell - Independent Financial Consultant
Phone (469) 708-9260 Secure Tax (612) 256-3002
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North Star Consultants - Celebrating over 110 years of business
7929 Brookriver Dr, Dallas, TX 75247 - Suite 760

Additional Resources

Jackie Fuller - Practice Assistant
jackie.fuller@northstarfinancial.com
Phone (512) 610-1803

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It is important to keep in mind that for a Roth IRA, earnings withdrawn prior to reaching age 59½ and/or not meeting the five-year holding period may be subject to a 10 percent penalty in addition to income tax. After-tax contribution amounts are generally returned income tax free; however, for Roth conversions, if converted amounts are not held for the five-year period, distributions may be subject to a 10 percent penalty.

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Financial Advisors do not provide specific tax/legal advice and this information should not be considered as such. You should always consult your tax/legal advisor regarding your own specific tax/legal situation.

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