Will your tax rate be higher now or in the future?
Funding an individual retirement account (IRA) can help you meet your retirement goals by providing tax advantages that allow your money to grow faster. But there are two basic options to choose from: Traditional IRAs and Roth IRAs, each with its own tax advantages. Which is best for you depends on several different factors, including your age, income and financial goals. But most people make their decision based on whether they want to save on taxes now, in which case they contribute to a Traditional IRA, or save on taxes after they retire, in which case they contribute to a Roth IRA. The government will get its tax money, either now or in the future. You can also fund one of each, up to the combined max, which is set by the IRS every year.
Here are the top considerations, but you can also see our handy infographic:
Contribution Limits Depend On Your Age
Anyone below age 49 with earned income can contribute to a Traditional or Roth IRA, up to the combined total of $5,500 for 2016. People age 50 and above can also tack on an additional $1,000 “catch up” contribution, for a total of up to $6,500. You can’t make regular contributions to a Traditional IRA in the year you reach 70½ and older. However, you can still contribute to a Roth IRA and make rollover contributions to a Roth or Traditional IRA regardless of your age.
Deductibility Depends On Your Income
Contributions to Traditional IRAs are only tax-deductible if the account owner has no access to a workplace retirement plan or has modified adjusted gross income of less than $71,000 in 2015 ($118,000 if married filing jointly). Deductibility is phased out starting at $61,000 ($98,000 if married). You can see the full 2016 contribution limits here. Roth IRA contributions aren’t deductible. In fact, you can only make contributions to Roth IRAs if you are a tax filer with modified AGI of less than $132,000 in 2016 ($194,000 for married filing jointly). You can see more of the contribution rules here.
Both IRA types provide tax breaks. Traditional IRA contributions are tax deductible when the account holder meets the eligibility requirements noted above. That means they reduce taxable income by the contribution amount—for both federal and state taxes—and taxpayers don’t have to pay taxes on their savings until they are withdrawn in retirement. That’s a big advantage because you can earn returns on the money in the account — and the returns are never taxed.Roth IRAs provide after-tax savings, meaning there’s no tax break today, but all contributions grow and can be withdrawn tax-free in retirement.
Future Tax Rates
So, which tax incentive makes the most sense for you? Much depends on whether your tax rate goes up or down in future—particularly during your retirement, when you withdraw the funds. That’s because the tax rate you pay now will be paid on Roth contributions, while the tax rate you pay in retirement will be paid on tax-deferred contributions, those you put in a Traditional IRA. Of course, you can’t accurately predict what your tax rate will be in 10, 20 or 40 years. Federal and state taxes rise and fall over time. However, you can try to make some educated guesses by answering some questions: What tax bracket are you in today—a high one or low one? How much total retirement income (including Social Security) do you expect to have, and will that put you in a higher or lower tax rate than today’s? Do you think the federal government’s financial issues today will force it to raise tax rates overall by the time you retire?Keep in mind that you might lose some valuable deductions and tax credits, such as those for your home mortgage or kids, in retirement that would increase your taxable income and tax rate, even if your gross income doesn’t rise.
A significant difference between Roth and Traditional IRAs is the withdrawal requirements. Required minimum withdrawals (RMDs), per IRS guidelines, must be taken from Traditional IRAs before the account holder reaches age 70 ½. No withdrawals are required from Roth IRAs during the account holder’s lifetime—making them ideal for extending the tax-free growth and passing it along to heirs. Beneficiaries of Roths also are not required to pay taxes on their withdrawals and can stretch out the tax-free growth of Roths for many years. Both types of IRAs allow owners to begin taking penalty-free, “qualified” withdrawals starting at age 59 ½ (though remember that Traditional IRA withdrawals are taxable).
Here are a few other distinguishing factors to consider when choosing between Roth and Traditional IRAs: Roth IRAs:
- Penalty-free withdrawals: All contributions to Roths—though not earnings—can be withdrawn without penalty at any time.
- First-time homebuyer benefit: Once the first contribution is at least five years old, up to $10,000 in earnings can be withdrawn to cover qualified first-time homebuyer costs, even if you’re not older than 59 ½.
- Other deduction opportunities: Because Traditional IRA contributions lower taxable income, they can push an IRA owner’s below certain thresholds, making them eligible for other tax benefits. For instance, only taxpayers with AGI below certain levels are eligible to take a deduction for student loan interest paid.
- First-time homebuyer benefit: Owners can withdraw up to $10,000 to pay for eligible first-time home purchase expenses without paying the usual 10% early-withdrawal penalty.