Roth vs Traditional IRA
When the words IRA come up, there can be a lot of confusion about what type of IRA is best for you. Don’t worry, you’re not alone.
Before you and your advisor can decide what’s best for you, it’s important to clearly understand what makes each type of IRA unique.
There is one major difference between a Roth IRA and the Traditional IRA.
Roth IRA funds are taxed before they are put into the account, and therefore cannot be taxed again.
Traditional IRA funds are tax-deferred and therefore are taxed upon withdrawal.
As your funds accumulate in your Roth IRA, they do so tax-free. Whereas with your Traditional IRA the more you invest, and the better growth in the IRA, the more tax you will pay.
Deciding on whether you should make a conversion to a Roth largely depends on your tax bracket but there are also some limits when it comes to your contribution eligibility (single people can contribute less than those who are married).
The main benefit to a Roth IRA is that if you begin your contributions early, when your income is lower, your IRA will grow tax free. If you expect to be in a higher tax bracket in your retirement than you are currently, a Roth IRA saves you income on taxes.
However, if you are currently in a higher tax bracket than you expect to be when you draw on your IRA, the traditional IRA is the best place to put your contribution, to avoid paying higher taxes on the income.
Backdoor Roth Contributions
Don’t worry, if you find you’re not eligible for a Roth IRA, there are strategies in place to help. If you have a Traditional IRA, you can convert those funds into a Roth IRA through a series of money movements.
Currently, there is an IRA Aggregation Rule that limits people from getting Roth IRA’s due to their income level. If this is you, what you can do is contribute around $6500 to a Traditional IRA and then wait. The waiting time can vary as some believe you have to wait 30 days while some believe you should wait a year, but nothing is written about it.
After this waiting period is over you should be able to convert to a Roth IRA with that $6500. Once established, you can begin to contribute to this fund regularly.
Another strategy to deal with the limitations of Roth's is to have a 401k plan or transfer your IRA to a 401k plan which makes you eligible to do a Roth conversion without any ramifications. By converting your funds to a Roth IRA, you can also ensure your money can grow tax-deferred for your children after you are gone.
Maximize Roth Conversions
If you find yourself in a very low tax bracket due to your deduction ability, it may make sense for you to use any remaining deductions to make small annual conversions. It’s great to take a portion of it and merge it into a Roth and now you have years of tax-free growth. You always have the option of having different accounts so that when you are in a higher tax bracket you can contribute to a traditional IRA, but you can also have money ready down the line where you are in a very low tax bracket.
Having a good IRA strategy is about looking at your current taxes and planning things over the long term to maximize your tax efficiency. Aside from doing small conversions, when you have a big loss in your business then it’s also a good way to take advantage of a Roth conversion. Of course, making a conversion is about looking at each person’s situation individually. Small conversions may not be earth shattering but it’s going to grow.
It’s important to have an individual understanding of the basics of IRA’s before you dive into your specific situation. With the complexity of tax laws, it is important to have a financial planner in your corner ensuring you’re making the right decisions for the long haul of your finances.