Retirement accounts like IRAs and 401(k)s are hugely popular—and the reason is their tax advantages.
But traditional IRAs and Roth IRAs are very different: Assets in your IRA grow tax-deferred, while assets in your Roth grow tax-free. And if you’re wondering what on earth that means, you’ve got plenty of company.
Generally, when you contribute money to a traditional IRA, your taxable income is lowered by the amount of your contribution. This is why contributions to traditional IRAs are known as “pre-tax”.
With a Roth IRA, on the other hand, the amount you contribute does not lower your current tax bill. Your “after-tax” contributions grow tax-free, and your deposits and earnings are ultimately withdrawn tax-free.
So why would anyone use a Roth rather than a traditional IRA? The answer: Once you turn 70½, you must pay Required Minimum Distributions (RMDs) each year. And if you’ve amassed a large amount of money in that IRA, your RMDs could trigger an equally large tax bills.
If you pass away with assets in your traditional IRA, your beneficiaries can face additional taxes as they take money out. If you’re a young saver with high income, opting for a traditional IRA will likely put you in this predicament decades from now. Conversely, in a Roth your beneficiaries would receive the funds tax free.
So young, high earners should only use Roth IRAs, right? Yes—as long as they qualify. In many cases, high income levels and other factors exclude people from using Roth IRAs.
What’s more, Roth IRAs aren’t always the best way to go. Take a high-tax-bracket couple who are closer to retirement and need to catch up on their savings. Because their timeline is shorter, tax-free growth takes a back seat to rapid accumulation. And that means a traditional IRA is the better choice with the immediate savings of lower income taxes.
Another factor that complicates the traditional-versus-Roth decision is whether you expect your income tax rate in retirement to be higher or lower than it is now. In some cases, you might end up paying a lower rate on your traditional IRA withdrawals than you’d pay now to make Roth contributions.
Simplifying complex decisions around IRAs is where a qualified financial advisor is really valuable. Our team helps clients cut through the confusion and determine whether a traditional IRA, Roth IRA or some combination of the two is best. In many cases, we are able to help them maneuver around eligibility roadblocks, through the use of so-called backdoor Roth conversions, or even using a Roth 401(k).
FPC can help you get started today. Give us a call or send an e-mail if you’d like to discuss the best ways to put IRAs, and their tax advantages, to work for you.
Bijan Golkar is a Certified Financial Planner™ and licensed tax preparer with FPC Investment Advisory Inc. in the San Francisco Bay Area.