Traditional IRA versus Roth IRA
Which Is Better - A Traditional IRA or a Roth IRA?
Here's a common question asked by investors everyday. Which is better: a Traditional IRA or a Roth IRA? While both have their advantages and disadvantages, each are fantastic ways to save for your golden years, but in almost all apples-to-apples comparisons, the Roth IRA is going to win. Quite frankly, a Roth IRA is the closest thing to a perfect tax shelter you're probably ever going to find. So much so that almost anyone who qualifies should definitely consider adding a Roth IRA to their investment toolbox.
Nevertheless, it is important that you understand the differences between the two accounts. Over the next five to ten minutes, let's examine both the Traditional IRA and the Roth IRA so you can get a better idea of how each one might fit within your overall portfolio.
Both a Traditional IRA and a Roth IRA Are Types of Accounts, Not Investments
Think of both the Traditional IRA and the Roth IRA as a type of box. Many different assets can go inside of it - stocks, bonds, real estate, mutual funds, index funds, money markets or certificates of deposit - but it's such a good deal, Congress limits the amount of money you can put into that box every year. This is known as a contribution limit. Depending upon which type of IRA you select, the tax consequences will be different.
An Overview of the Traditional IRA
- Contributions are tax deductible at the time they are made for individuals and families earning less than the income limitations in effect for any given year, which are regularly updated by the IRS. For example, a couple of years ago, I detailed the then-in-effect Traditional IRA income limitations for tax year 2014 to demonstrate how the rules work. However, even if you exceed the Traditional IRA income limits for tax deductibility, you can still take advantage of the tax-deferred compounding (see next point). The contribution limits themselves consist of a "base" contribution limit and a "catch-up" contribution limit that people 50 years or older can use, if they like. For example, in 2015, the base contribution limit was $5,500 and the catchup contribution limit was $1,000, so a person who was 52 years old, and otherwise qualified for a Traditional IRA, could contribute $6,500 to his or her account.
- The years in which your money is sitting in your Traditional IRA, as long as you follow the rules, you shouldn't owe any taxes on any of the investment profits you generate. That means no taxes on capital gains and no taxes on dividends, interest, and rents. Even if you find yourself sitting on millions upon millions of dollars in profits, as long as it is within the protective confines of the account, the Federal, state, and local governments get none of it.
- You can begin making withdrawals from your Traditional IRA at the age of 59.5 years old without having to pay the early withdrawal penalty. You must begin taking withdrawals, and paying tax upon those withdrawals (all withdrawals are taxed, including past contributed principal since it was tax-deductible at the time the contribution was made), by the age of 70.5 years old so you can't accumulate too much money in the tax shelter.
- Traditional IRAs and Roth IRAs are extremely useful asset protection tools. Under the present three-year bankruptcy protection limit set on April 1, 2016, which is adjusted every three years, an investor can have up to $1,283,025 in combined balances across both types of IRAs and have it exempted from creditor claims. Married couples can effectively double this amount since both the Traditional IRA and Roth RIA must be owned by an individual (there's no such thing as a jointly owned IRA). This is one of the major reasons it is almost always wise to seek the counsel of a qualified, respected bankruptcy attorney prior to any serious decisions when you are facing financial hardship. The worst thing you can do is draw down your Traditional IRA or Roth IRA balance then declare bankruptcy, anyway, as you've cost yourself years, perhaps even decades, of rebuilding when you could have emerged from the courthouse with your retirement funds intact.
An Overview of the Roth IRA
- Contributions to a Roth IRA are not tax deductible at the time they are made. However, unlike a Traditional IRA and subject to certain minimal conditions, if you need to make a withdrawal of your past principal contributions, you can do so tax-free without an early withdrawal penalty, though you won't be able to replace the funds, again, once they've left the account. There are tax consequences for any investment gains or other funds in excess of the historical contributions into the Roth IRA if taken before the age of 59.5 years old.
- During the years the money is in the Roth IRA, as long as you follow the rules (e.g,. don't use borrowed money that leads to the unrelated business income tax, don't invest in MLPs, etc.), any profits you generate should all be tax-free.
- There is no mandatory distribution age. If you live to be 105 years old and end up with a $25,000,000 Roth IRA because you discovered the next McDonald's, Home Depot, Microsoft, Apple, or Berkshire Hathaway, you aren't going to have to give a dime of it to Federal, state, and local governments were you to make a withdrawal and begin spending it under the present rules.
- The same bankruptcy protections that cover the Traditional IRA also cover the Roth IRA (see above).
- The tax shelter benefits are so extraordinary for a Roth IRA that Congress specifically limits it to individuals and families with adjusted gross incomes of less than certain pre-determined thresholds. These are updated every year. A few years ago, I broke out the then-in-effect 2014 Roth IRA income limit rules, which can serve as a useful template for understanding how the calculations work.
The tax benefits of the Roth IRA are so extraordinary that many Americans who don't qualify because they make too much money engage in a technique called a "backdoor Roth IRA" that involves funding a Traditional IRA, then converting it to a Roth IRA.
Where Can I Open a Roth IRA or Traditional IRA?
As previously mentioned, a Roth IRA and a Traditional IRA are both types of accounts, not investments, so you can open either with many different types of financial institutions. If you go to a bank or credit union, they might offer either IRA but only allow you to put certificates of deposit into them. If you own either type of IRA with a discount brokerage firm such as Charles Schwab or Scottrade, you can put almost anything that is publicly tradable into it, including exchange traded index funds such as SPDRS or blue chip stocks. Some investors who exclusively use mutual funds for their retirement needs prefer to open a Traditional IRA or Roth IRA directly with a mutual fund family such as Fidelity or Vanguard.
How Much Money Do I Need To Open a Roth IRA or Traditional IRA?
The minimum opening balance for either type of IRA is determined by the financial institution with which you are opening the account. Some require $1,000 to $3,000. A few will allow you to kick in as little as $100 on the condition that you save at least so-much per month for a given period of time to demonstrate you are serious about building wealth.
Can I Have Both a Traditional IRA and a Roth IRA?
Absolutely. Millions of Americans do. You can even add funds to both in the same year provided your total, combined contribution doesn't exceed the contribution limits in effect for the year. For example, in a year where a person who is 37 years old can only contribute a total of $5,500, that person could put $2,000 in a Traditional IRA and $3,500 in a Roth IRA because, combined, they are still at, or under, the $5,500 limit. If you exceed the contribution limits and don't rectify it within a certain window of time, the government will assess confiscatory taxes that will ultimately wipe out the surplus balance.
Can I Have a Roth IRA and/or Traditional IRA Plus a Retirement Account at Work?
Yes. In addition to funding a Roth IRA or Traditional IRA each year, you can also fund a Traditional 401(k), a Roth 401(k), a Solo 401(k), a 403(b), SEP-IRA, SIMPLE IRA, or other qualified plan. These often have other advantages of their own, including unlimited bankruptcy protection on top of the bankruptcy protection offered on the IRAs discussed in this article.