Podcast Episode Overview
In this episode, I answer a listener question about how to save for retirement. Specifically, “Should I be using a traditional IRA, Roth IRA, or both for retirement saving?”
In order to answer this question, I provide a general overview of the features for both a Traditional and Roth IRA. When you have the option between a Traditional IRA or a Roth IRA it is important to understand the similarities and differences. I break down the pros and cons for each of these tax-advantaged accounts. Finally, I provide some rules of thumb which you can choose to make a decision on which type of IRA best fits your situation.
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Show Notes and Outline
“Should I be using a traditional IRA, Roth IRA, or both for retirement saving?”
Overview of a Traditional IRA
- Tax-deductible in the current year (with some restrictions)
- If covered by a retirement plan at work:
- If single or HOH, a full deduction up to $63,000 in AGI
- Married filing jointly households receive a full deduction up to $73,000 in AGI. Trails off after that.
- If not covered by a retirement plan at work: Gets much more complicated. Basically, if you and your spouse both don’t have a retirement plan at work, then you can always deduct your contribution.
- However, if your spouse has a retirement plan and you don’t, then you can deduct the full amount as long as your AGI is below $189,000.
- If covered by a retirement plan at work:
- Don’t pay any taxes on capital gains, dividends, or interest until withdrawn. (Tax deferral)
- Pay taxes when withdrawn.
Overview of a Roth IRA
- NOT tax deductible in the current year.
- Don’t pay any taxes on capital gains, dividends, or interest while in the account. (Tax deferral)
- No taxes owed when withdrawn in retirement.
- Contributions are restricted in part or whole once your income exceeds a certain limit. ($120,000 single or HOH, and $189,000 married filing jointly)
Key Similarities between a Traditional IRA and Roth IRA
- The contribution limit is the same at $5,500 or $6,500 if over 50 years old
- Both accounts provide tax deferral
- Both involve a tax penalty for withdrawals of earnings under the age of 59 and a half.
Key Differences between a Traditional IRA and Roth IRA
- Tax Deductible (Trad) or Tax Exempt (Roth)
- No required minimum distributions for the Roth IRA
Which is better? It all comes down to your assumptions
- Current Income / Tax Rate
- High current income prefers traditional IRA
- Low current income prefers Roth IRA
- Retirement Income / Tax Rate
- High retirement income prefers Roth IRA
- Low retirement income prefers Traditional IRA
- Will income taxes go up over time, stay the same, or be reduced?
- This is the absolutely most important thing to consider. Many people when doing this analysis simply assume that Tax Rates will remain constant. This is a BAD assumptions. Tax rates change all the time.
- Government debt is increasing, and at some point tax rates will have to rise.
- Now, it might not be INCOME TAX rates that rise. A national sales tax or VAT is also a possible way of raising income.
The answer: Should you use a traditional IRA or a Roth IRA or both for retirement saving?
- Short answer: It depends
- Long answer: I’ll dive into some rules of thumb which should help, and some general thoughts on how I think about it.
Rules of Thumb:
- If you make less than the standard deduction (12k singles, 24k married) you’re in the 0% tax bracket. This is an obvious choice. You should save in a Roth IRA.
- The same is also true for the 10% and 12% tax brackets.
- Basically, if you make up to $50,700 single or up to $101,400 married in gross income, you should be contributing ONLY to a Roth IRA.
- Your goal SHOULD be to build enough wealth that you would otherwise be in a higher tax bracket when you retire. You also have the added benefit of not having to make required minimum distributions.
- What about as you get higher in income? At some point, it might make sense to use a traditional IRA. However, that’s only true if you fall into a specific category. Something along the lines of early retirement or financial independence mindset. Where you make a lot of money now and live on a very small amount. Therefore, when you retire you can retire on a lower income than you earn now.
- If that’s the case, you should absolutely be using a traditional IRA. because you’ll pay no taxes when the money goes in, and little to no taxes when you withdraw the money.
Should you use both? NO.
- It’s pretty simple. There is a right and a wrong answer depending on where you are in the income stream and your plans. Doing both just means you don’t understand your retirement goals.
My default: Roth IRA.
- Tax Exempt is better than tax deductible. I also intend to save a lot of money and become wealthy in retirement. If I’m successful, I will retire at a much higher tax bracket than I’m working at. This is mainly driven by time and compounding. I want to protect all of my money from future taxes if I can.
- But also, I don’t want to be subject to required minimum distributions.
Sources:
- https://www.irs.gov/retirement-plans/individuals-retirement-arrangements-getting-started
- https://www.irs.gov/retirement-plans/traditional-and-roth-iras
- https://www.irs.gov/retirement-plans/ira-deduction-limits
- https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work
- https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-not-covered-by-a-retirement-plan-at-work
- https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2018
- https://www.forbes.com/sites/kellyphillipserb/2018/03/07/new-irs-announces-2018-tax-rates-standard-deductions-exemption-amounts-and-more/#1d9e75e33133
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