IRAs are a powerful tool for your retirement savings. In this post we review: What is an IRA? What's the difference between Roth and Traditional IRAs? And how should you decide between the two?
What is an IRA?
An IRA is an Individual Retirement Account that offers tax benefits to retirement savers. In 2022, individuals are allowed to contribute $6,000 to their IRA ($7,000 for those age 50 and older).
IRAs primarily come in two different types: Roth and Traditional.
What’s the difference between Roth and Traditional IRAs?
The main difference between Roth and Traditional IRAs is tax treatment.
- Roth IRA contributions are made after-tax, contributions grow tax-free, and withdrawals are tax-free.
- Traditional IRA contributions are made pre-tax, contributions grow tax-deferred, and withdrawals are taxed as income.
When contributing to a Roth IRA you pay taxes today (you don’t get a tax break), but your earnings and withdrawals are tax-free.
Your contributions to a Traditional IRA provide a tax deduction today and your earnings grow tax-deferred. But when you make withdrawals in retirement, the withdrawals are taxed as income.
Required Minimum Distributions (RMDs)
Traditional IRAs are subject to Required Minimum Distributions (RMDs). Roth IRAs are not.
Although you receive an immediate tax deduction for Traditional IRA contributions (assuming you are under the income limit) and your contributions grow tax-deferred, you will be required to make withdrawals (and pay taxes on those withdrawals) once you reach RMD age.
Under current law, RMDs begin at age 72. Once you turn 72, you are required to withdraw a certain amount each year according to the Uniform Lifetime Table, or you will be subject to a 50% tax penalty on undistributed amounts.
Because you have already paid taxes on contributions made to Roth IRAs, these accounts are not subject to RMDs. (Note: RMDs do apply to Roth 401(k)s, but taxes are not assessed on these withdrawals.)
Withdrawals from a Traditional IRA prior to age 59 ½ are subject to taxes and an early-withdrawal penalty of 10% on the entire withdrawal.
Withdrawals of contributions to a Roth IRA prior to age 59 ½ are tax and penalty-free. But withdrawals of earnings will be subject to taxes and the 10% penalty.
Income Limits and Phaseouts
Roth and Traditional IRAs are subject to several income limitations. These limits are based on your Modified Adjusted Gross Income (Modified AGI).
Modified AGI is calculated by taking your Adjusted Gross Income (AGI), found on the front page of your Form 1040, and adding back certain deductions. The added-back deductions include student loan interest, one-half self-employment taxes, and other items.
Roth IRA Income Limits
You are allowed to make direct contributions to a Roth IRA only if your income is below certain thresholds.
In 2022, the modified AGI phase-out ranges for Roth contributions are:
- Single: $129,000 to $144,000
- Married Filing Jointly: $204,000 to $214,000
For example, assume you are married and filing jointly in 2022. If your modified AGI is below $204,000, you and your spouse may each contribute the full amount to a Roth IRA.
If your modified AGI is $206,000, you are 20% into the phaseout range ($2,000 into the $10,000 range). Therefore, you can contribute 80% of the annual limit to a Roth IRA. In this example you could contribute $4,800 ($6,000 * 80%).
Although you may not be able to directly contribute to a Roth IRA due to these income limits, you may be able to contribute through a Backdoor Roth IRA or perform Roth conversions to boost your tax-free assets.
Traditional IRA Deductibility
If neither you nor your spouse are covered by a workplace retirement plan (401(k), 403(b), etc.), you can always deduct contributions to a Traditional IRA.
But if either you or your spouse are covered by a workplace retirement plan, then income limits apply to the deductibility of your IRA contributions.
In 2022, the tax-deductibility of Traditional IRA contributions phase out at the following income levels:
- Single: $68,000 to $78,000
- Married Filing Jointly: $109,000 to $129,000 for the taxpayer covered by a workplace plan, $204,000 to $214,000 for the taxpayer not covered by a workplace plan
For example, assume you are a single taxpayer with a modified AGI of $73,000 (50% into the phaseout range). If you contribute $6,000 to a Traditional IRA, you will be able to deduct $3,000 for tax purposes.
If you are above these income limits, you can still make a non-deductible contribution to an IRA. You will not receive a tax deduction for your contribution, but earnings will grow tax-deferred within your IRA. When you make withdrawals in retirement, you will not be taxed on the non-deductible contribution portion of your IRA.
Traditional vs. Roth 401(k)s
The tax treatment of Traditional and Roth 401(k)s is the same as IRAs, but there are no income limits.
Roth 401(k) contributions are allowed regardless of income. And Traditional 401(k) contributions are deductible regardless of income.
Employer contributions to your 401(k) (matching programs, profit-sharing) are pre-tax contributions, even if you are making Roth contributions.
Should I make Roth or Traditional contributions?
The key determinant of which type of retirement contribution is right for you is your current marginal tax rate and your expected marginal tax rate in retirement.
- If you believe your current tax rate is lower than it will be in retirement, then Roth contributions are appropriate. You would want to pay taxes now and make tax-free withdrawals in retirement.
- If you believe your current tax rate is higher than it will be in retirement, then Traditional contributions are appropriate. You would want to take the tax deduction today and pay taxes at the lower rate in retirement.
Below are Federal Income Tax rates for 2022:
Determining your Current Tax Rate
Your taxable income can be found on your Form 1040. Line 15 shows your taxable income.
You can use this Form 1040 to estimate your taxes and determine which tax bracket you will fall into. The above table shows Federal tax rates, but state income taxes should also be considered.
You can also use an income tax calculator to estimate your current and future marginal tax rates.
Estimating Taxes in Retirement
Your income in retirement may consist of social security, pension, pre-tax retirement withdrawals, investment income, rental income, and other sources.
Roth vs. Traditional IRA Examples
The following are three examples that demonstrate the impact of current and future tax rates on the value of Roth vs. Traditional retirement savings.
In each example, we assume gross savings of $10,000, 8% annual growth, and a 20-year time horizon. The only difference is relative tax rates today and in the future.
Example 1: Current Tax Rate < Future Tax Rate
If you are in a lower tax bracket today than you expect to be in retirement, a Roth contribution is preferable. This is often the case if you are early in your career. Or you may have a low-income year due to taking a sabbatical or starting a business.
In the below example we compare the after-tax value of a Roth and Traditional IRA, assuming a 12% tax rate today and 22% in retirement.
Although the initial Roth contribution is reduced by the 12% tax rate and the account value is lower at the time of withdrawal, the after-tax amount is greater because taxes are not assessed on the Roth at the higher 22% rate. The Traditional IRA grows to a greater pre-tax value, but ends up behind the Roth net of taxes.
Example 2: Current Tax Rate > Future Tax Rate
If you believe you are in a higher tax bracket today than you will be in retirement, then a Traditional contribution is preferable. This is common in your peak earnings years, typically your 40s and 50s.
The below example compares Roth and Traditional retirement savings with a current tax rate of 32% and a future tax rate of 22%.
In this example, the after-tax value of the Traditional IRA is greater than the Roth IRA.
Example 3: Current Tax Rate = Future Tax Rate
If the tax rate today is the same as the future tax rate, then the after-tax value of the accounts will be the same. Below we assume a 22% tax rate today and in retirement.
Deciding between Roth and Traditional contributions will be less impactful in this situation. However, the increased flexibility of Roth IRAs may help to break the tie. As mentioned previously, you may withdraw Roth contributions prior to retirement penalty-free and Roth IRAs are not subject to RMDs.
Tax Considerations: Future Tax Rates and State Income Taxes
Although we can have an excellent understanding of our taxes today. Tax rates in the future are far less certain. When deciding between Roth and Traditional contributions, it's also important to consider your expectations for future tax rates and state income taxes.
Future Tax Rates
We do not know what tax rates will be in the future. But we are living in a historically low-tax environment. Therefore, it's fair to assume tax rates are unlikely to fall meaningfully lower.
The Tax Cuts and Jobs Act (TCJA) reduced personal income taxes significantly in 2018. Below is a comparison of 2018 Federal income tax rates before and after the legislation.
These personal income tax changes are set to expire after 2025. Meaning these tax rates will revert to the pre-TCJA levels. This will be most meaningful in the middle-income ranges. The 12%, 22%, and 24% brackets will revert to 15%, 25%, and 28%.
Again, we do not know what tax rates will be in the future. But unless Congress acts, tax rates will increase for most individuals and families in the near future.
All else equal, this is supportive of Roth contributions at these middle-income levels.
State Income Taxes
Your state income taxes must also be considered in this equation, especially if you plan on moving in retirement.
If you currently reside in a high-income tax state but plan to move to a low- or no-income-tax state in retirement, then Traditional contributions may be preferable. Alternatively, if you currently reside in a low- or no-income-tax state, then Roth contributions may be more attractive.
For example, if you and your spouse live in Vermont and earned $150,000 in 2021, your total marginal income tax rate is 28.6% (22% Federal, 6.6% State).
If you plan to move to a no-income-tax state, then your marginal tax rate would be 22%. In this situation, you would want to make a Traditional contribution (avoiding the current 28.6% rate) and withdraw funds in retirement at the 22% rate.
And even if you think tax rates may increase in the future, Federal rates would need to climb by more than 6.6% to make a Traditional contribution unattractive in this example.
As you can tell, the decision to contribute to a Roth or Traditional IRA or 401(k) is not always cut and dry. If we knew all the variables (future earnings, tax rates, legislative changes, etc.), then we could make the "right" decision. Instead, we must make informed decisions based on the best information we have today.