How to Choose the Right Type of Retirement Account
When it comes to saving for retirement, one of the most common questions clients ask is, “What’s better, a Roth IRA or a traditional IRA?” The answer is that there are pros and cons to both types of accounts, and the one most advantageous to you depends on your personal financial situation and goals for the future.
The Basics
As a refresher, let’s review the differences between traditional and Roth IRAs.
Traditional IRA Roth IRA
Tax-advantaged growth Tax-deferred growth – no federal taxes are due until distributions are taken. Tax-free growth – No federal taxes are due as long as the account has been open for five years and the account holder has reached age 59 ½.
Distributions Distributions are taxed as ordinary income. Contributions can be withdrawn at any time with no taxes or penalties. Qualified withdrawals (those made after age 59 ½ and after the account has been open at least five years) are tax-free.
Early withdrawal penalties Distributions before age 59 ½ may be subject to a 10% early withdrawal penalty and are taxed as ordinary income. Distributions of money contributed can be taken tax-free. Investment growth may be subject to a 10% early withdrawal penalty if taken before age 59 ½ or if the account has been open for less than five years.
Required minimum distributions (RMDs) RMDs must begin once the investor reaches age 73. No RMDs required for the account owner’s lifetime. (Account beneficiaries of inherited Roth IRAs may be subject to RMDs.)
Contribution type Contributions are made on a pre-tax basis, which reduces the taxpayer’s taxable income in the year contributions are made. Contributions are made on an after-tax basis, which provides no immediate tax benefit.
Eligibility Anyone of any age with earned income can contribute. Higher income earners are phased out from contributing.
Annual contribution limits 2022: $6,000 for those under age 50 with an additional $1,000 catch-up contribution permitted for those age 50 and older.
2023: $6,500 for those under age 50 with an additional $1,000 catch-up contribution permitted for those age 50 and older.
2022: $6,000 for those under age 50 with an additional $1,000 catch-up contribution permitted for those age 50 and older.
2023: $6,500 for those under age 50 with an additional $1,000 catch-up contribution permitted for those age 50 and older.
Which type of IRA is better?
As with many financial planning-related questions, the answer is, “it depends.” The following considerations can help you determine which type of IRA makes sense for you.
- Modified Adjusted Gross Income (MAGI) – In 2022, if your MAGI is greater than $144,000 as a single filer, or $214,000 married filing jointly, you are not eligible to contribute to a Roth IRA. (Contributions are gradually phased out for those with MAGIs between $129,000 and $144,000 for single filers or $204,000 to $214,000 for those who are married filing jointly.) This means contributions to a traditional IRA are your best (and only) option.
- Current and future tax brackets – As a general rule of thumb, if you expect to fall into a lower tax bracket in retirement, you may want to make pre-tax contributions to a traditional IRA to lower your current (higher) income. If you expect to fall into a higher tax bracket in retirement, contribute to a Roth IRA to enjoy tax-free retirement income.
- Other sources of retirement income – Similar to the benefits of diversifying your investment types, tax diversification across account types can help reduce long-term risk and provide advantages when it comes time to establish a monthly income in retirement.
As a starting point, always contribute at least enough to your 401(k) to take full advantage of any employer matching contributions available to you. If you’re earlier in your career and expect your income to rise over time, consider contributing to a Roth IRA before you are phased out from doing so. If you max out your retirement contributions, consider setting aside additional assets in a taxable brokerage account. The benefit to doing so is that assets held for at least one year are subject to capital gains rates (instead of ordinary income tax rates) when withdrawn at retirement.
Although income in a brokerage account is typically taxable, you can reduce your tax liability by investing in tax-efficient assets, such as exchange-traded funds, tax-managed funds, index mutual funds and municipal bond funds.
There are certain situations in which it may make sense to convert your traditional IRA to a Roth IRA. However, because there can be significant tax consequences during the year in which you make a conversion, it’s always wise to consult with your wealth advisor prior to making a move.
Are you interested in learning more about how to save for retirement? Creative Planning is here for you. Our experienced teams take time to get to know you, your current financial situation, your goals for the future and any challenges you may face before offering well-informed, custom solutions to meet your needs. For more information, please schedule a call with a member of our team.
