29 Mar 2017
Traditional IRAs were established back in 1974 and most of us are pretty familiar with them. It wasn’t until 1997 that the Roth IRA was created, providing tax payers with an additional way to save for retirement.(1) Deciding on which one to select depends on your eligibility and your income tax rate. With a Traditional IRA, savings are contributed pre-tax. You will save on your tax bill today but will owe taxes upon withdrawal. With a Roth IRA, contributions are made post-tax and withdrawals are taken tax-free. To help determine which plan is best for you, you’ll need to consider your current tax rate and your expected tax rate in retirement, as well as some other factors.
Why select a traditional IRA?
Traditional IRAs lower your current tax liability. If you are in a high tax bracket now and expect to be in a lower bracket at retirement, a traditional IRA may be right for you. Also consider that a full dollar will be invested because you are contributing pre-tax. For example, a person in the 38% tax bracket would have only 62 cents to invest after taxes as compared to $1 pre-tax.
You can contribute if you or your filing-jointly spouse have taxable income and you are under age 70. There are no income limits. You can each contribute $5,500 to your plan per year; at age 50 and over, you can “catch up” with a $6,500 per year contribution.(2) Your contributions are generally tax deductible and you only pay taxes when you withdraw the money.
You can have a 401k plan at the same time, but may not be able to deduct your entire IRA contribution from your taxes.
Withdrawals are allowed after age 59½ and are taxed as regular income. Withdrawals made before the age of 59½ are subject to taxes and a 10% penalty fee (2) (except for penalty-free withdrawals of up to $10,000 to cover first-time homebuyer expenses, though taxes are due on distributions).
There may be an extra benefit in that an IRA contribution may lower your adjusted gross income enough to potentially qualify you for other tax incentives.
Required minimum distributions (RMDs) on a traditional IRA begin at age 70½; beneficiaries pay taxes on inherited IRAs. You can make your 2016 contribution up until April 17, 2017.
Who would invest in a Roth IRA?
People in a low tax bracket who expect to eventually be in a higher tax bracket may elect to contribute to a Roth. Since contributions to a Roth are made after paying taxes, the owner is paying taxes at their current rate, not a potentially higher future tax rate. The Roth may also be a good way to pass assets to heirs, tax-free, and can be used in estate planning. Since there are no RMD requirements with a Roth, distributions won’t increase your tax burden later on.
You can contribute to a Roth if you or your filing-jointly spouse earns taxable income, regardless of age. Roth IRA contributions are subject to income limits and you should consult your accountant for those amounts. You can have a 401k plan at the same time. You can contribute up to $5,500 per year and up to $6,500 per year for ages 50 and older. While contributions to the Roth are not tax deductible, there will generally be no tax liability on all future growth and withdrawals.(2) Contributions can be withdrawn at any time, tax-free and penalty-free. Withdrawals after age 59½ are tax-free as long as the account is at least five years old. Withdrawals before age 59½ usually have a 10% penalty tax on gains. No withdrawal is required during the account holder’s lifetime and beneficiaries can stretch distributions over many years.
The Roth IRA also has an extra benefit: after five years, up to $10,000 of earnings can be withdrawn penalty-free to cover first-time homebuyer expenses.
Many 401Ks offer Roth contributions. You can contribute up to $18,000 annually (and up to $24,000 for ages 50 and over) with no income limitations.
Note: Both traditional and Roth IRAs are subject to estate taxes if the estate is over the allowable federal limits.
1Roth IRAs: https://www.irs.gov/retirement-plans/roth-iras
2Source: Spors, K. (2016). Traditional IRA vs. Roth IRA http://www.rothira.com/traditional-ira-vs-roth-ira
Amy Weiser is a Financial Advisor with Morgan Stanley Global Wealth Management in Stamford, CT. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice.Morgan Stanley Smith Barney, LLC, member SIPC.