To save or not to save for retirement is not the question. For most investors, the question that matters is which retirement savings strategy is more beneficial: Roth IRA or traditional IRA.
With a Roth IRA or 401(k), the investor pays taxes on contributions, but once they are 59 ½ or older, account withdrawals, including any gains, are tax-free. With a traditional IRA or 401(k), the investor puts off paying taxes on contributions until they begin making withdrawals. At that time, however, they pay taxes on their contributions and account earnings.
Which strategy makes more sense depends on the investor’s tax bracket and earnings potential, but that does not mean they have to choose one over the other. Thanks to a handful of different strategies, savers can get the benefits of both pre-tax contributions and tax-free gains.
Basic Considerations: Current Income & Future Earnings Potential
When choosing between contributing to a Roth or traditional account, the biggest factors to consider are the income limits for IRAs, your tax bracket, and your future earning potential.
- Income limits
Individual investors whose adjusted gross income (AGI) exceeds $71,000 (or $118,000 for married couples filing jointly) aren’t eligible to make tax-deductible IRA contributions. Individuals whose AGI is $61,000 or lower ($98,000 for married filing jointly) can take the full deduction for their IRA contributions in 2015.
There is one exception; investors who do not have an employer-sponsored retirement account at work qualify for tax-deductible contributions regardless of income.
- Future earnings
Future earnings potential, on the other hand, plays a role choosing between Roth and traditional IRA options. A Roth IRA or 401(k) does not give you an upfront deduction, but the earnings grow and can be withdrawn tax-free. “Someone in an entry level job working on their MBA, who will have the opportunity to amass significant savings over time, is better off paying taxes upfront,” says Christine Benz, director of personal finance at Morningstar. But if you have already reached your peak earnings level and find yourself in a higher tax bracket than you believe you will be in upon retirement, the upfront deduction of a traditional IRA account may make more sense.
Mix and match to get the most out of an IRA
“If you put a thousand financial advisors in a room, [a third of them] will tell you to put everything in pre-tax [accounts] and a third will tell you to put it in a Roth. I’m in the camp [that says] do a little of both,” says Larry Rosenthal, a Certified Financial Planner and president of Rosenthal Wealth Management Group.
Additionally, as your tax bracket and income can change over time, so too should the way you save for retirement.
Most people in the 25-to-35 year age range are typically on the lower side of their potential earnings and may benefit from a Roth IRA, says Rosenthal. The ideal time to begin saving in a traditional IRA is once an investor moves to a higher tax bracket (assuming they still qualify for the deduction), so they can take advantage of a bigger write-off.
401(k) considerations: Roth or Traditional
Increasingly, employers are beginning to offer a Roth option within their 401(k) plans. This can be a boon to investors who are phased out of Roth IRA contributions, but believe that their tax bracket will be higher in retirement. “The Roth 401(k) doesn’t have any income restrictions, so it’s a good way to get some tax-free growth if you can’t contribute to a Roth IRA,” says Robert Brokamp, senior advisor at The Motley Fool.
Backdoor IRA rollover
Roth IRAs have income eligibility requirements that may disqualify higher earners from contributing:
Roth IRA eligibility for 2015:
- Individuals with AGI between $116,000 and $131,000 and married couples filing jointly who earn between $183,000 and $193,000 qualify for a reduced contribution.
- Those with AGI higher than the upper limits above do not qualify for Roth contributions.
One way around those requirements is a backdoor Roth IRA. With this strategy, investors contribute to a traditional nondeductible IRA, which is available to anyone regardless of income, and then convert that to a Roth.
There is, however, a caveat to this strategy for investors who already have assets in a traditional or rollover IRA (with assets that have not yet been subject to taxation); the taxable portion of the conversion will be prorated over all IRA assets. In order to take advantage of the backdoor Roth conversion, the investor will need to convert all other IRA accounts to Roth. This may present an investor who has a large pre-tax IRA balance (including any rollover IRAs) with a sizable tax bill. Before taking any steps, it’s best to consult with a tax professional, such as a CPA.