Retirement April 30, 2015

    You're ready to open an IRA—maybe to supplement an existing retirement account, or to jump-start your long-term plan. But which type of IRA is best for you: a traditional IRA or a Roth IRA?

    They each offer distinct tax advantages, and they each have some restrictions to consider. It won't take long to review what those are. You can then decide which account you'd prefer (or whether opening one of each might make sense).

    Some key points of distinction

    The primary difference between these two IRAs is the way in which the tax advantages are structured.

    If you're eligible for a deductible traditional IRA, the money you deposit counts as a deduction on your tax return for the year in which the contribution is made. To be specific: If you deposit the maximum of $5,500 total this year, you may be eligible to deduct that amount on your tax return for 2015, lowering your taxable income and thus your tax bill. You can even make a contribution for the prior year up until April 15.

    That said, although you may contribute pre-tax dollars to a traditional IRA, you do pay tax on your money and earnings when you withdraw them in retirement.

    With a Roth IRA, you deposit money that you've already paid taxes on; that is, you're contributing after-tax dollars. So you pay taxes based on the current tax rate for that year—and then you owe zero tax when you withdraw the money and the earnings in retirement.

    One thing to bear in mind: With a Roth IRA or traditional account, the term IRA, or "individual retirement arrangement" refers to the type of account that it is. It's not a type of investment (like a stock or bond). After you open the account, you then put your money into a portfolio of investments. More on that below.

    Rules, restrictions and some exceptions

    There are a few other points that distinguish traditional and Roth IRAs. Here are some fundamentals, but as with many financial issues, there are asterisks and exceptions, so please read the chart that follows to gauge which details are most relevant to your situation. Basically:

    • Roth IRAs have pretty strict income caps that limit whether you can make a contribution; traditional IRAs don't have any earned income caps for making a contribution, but there are some restrictions if you want to deduct the contribution and you're eligible for a pension plan or 401(k) plan at work.
    • If you withdraw earnings or deductible contributions from a traditional IRA before age 59½ you could pay federal taxes and a 10% federal penalty (state taxes and penalties may also apply; there are some exceptions to both federal and state taxes and penalties).
    • In contrast, you can withdraw contributions from your Roth IRA at any time without tax or penalty; earnings are tax- and penalty-free if you're 59½ or older and have held the Roth IRA for five years.
    • Starting the year you turn 70½, you must take required minimum distributions (RMDs) from a traditional IRA; there are no required withdrawals from a Roth for the original account owner (minimum distributions may apply to beneficiaries).
    At a Glance: Roth IRA vs. Traditional IRA
    • Contributions are not tax deductible.
    • Earnings can grow tax-free.
    • Contributions may be tax-deductible.
    • Earnings and deductible contributions can grow tax-deferred.
    • Contributions are always tax- and penalty-free.
    • After age 59½ and if the account has been open 5 years, earnings are tax- and penalty-free.
    • Distributions are not required.
    • After age 59½ earnings and previously deductible contributions are penalty-free but taxed as ordinary income.
    • You must begin taking contributions at age 70½.
    Your Account
    • Use money you've earned.
    • Convert a traditional IRA to a Roth IRA.
    • Roll over an old 401(k).
    • Transfer an IRA.
    • Use money you've earned.
    • Roll over an old 401(k).
    • Transfer an IRA.
    • You aren't eligible for a Roth IRA if you income is above a certain level.
    • Anyone with earned income can contribute to a traditional IRA.
    • Some contributions may be tax-deductible.
    Age Guidelines
    • N/A
    • Before reaching 70½, you can contribute if you have earned income.
    Investment Options
    • Mutual funds, stocks, bonds, ETFs, CDs, and money market funds.

    Traditional or Roth: how do you decide?

    Which IRA is "better" boils down to which one may best address your situation. If you expect to be in a higher tax bracket when you start withdrawals, a Roth IRA may make more sense. If you're in a higher tax bracket later on, the tax-free income may be more valuable than a deduction today, while you're in a lower bracket. On the other hand, if you expect to be in a lower tax bracket down the road, a deductible traditional IRA might be a better choice now, as the tax deduction is more advantageous while you're in a higher bracket.

    Imagine Evan, who's 35 and single, falls within the 25% federal tax bracket. He believes he'll stay within that bracket until retirement; and he's made an educated estimate that his tax bracket will then fall to 15%. Evan's best option might be opening a traditional IRA, because his distributions, when taxed, will be at the 15% post-retirement rate. Plus, he's claimed tax deductions along the way.

    Jasmine is also 35 but just got her Ph.D., and although her current federal tax bracket is only 15%, she anticipates higher earnings as her career ramps up. This might put her in a tax bracket as high as 28% by the time she retires. The tax-free retirement withdrawals available via a Roth could be more advantageous for Jasmine, even though she'll forgo the tax deductions along the way.

    Generally speaking, a Roth IRA will be better for younger workers who have yet to reach peak earning years, while a deductible traditional IRA will generally be better for higher income workers closer to retirement. Of course, there are plenty of exceptions to the general rule, and anything can happen with respect to future tax rates regardless of your current circumstances. If you're on the fence, it might make sense to increase your future flexibility by creating some tax diversification with both a Roth and a traditional IRA. The catch here is that you can't save more than the maximum for all your IRAs combined. So if you have a Roth and a traditional IRA, your combined contributions across all IRAs can't exceed $5,500—or $6,500 if you're age 50 or over.

    Choosing investments for your IRA

    Once you (and Evan and Jasmine) have opened the IRA of your choice, it's time to set your asset allocation and pick your investments. Schwab Intelligent Portfolios™ can help investors holding either or both types of IRAs by providing an automated investment advisory service composed of low-cost, well-diversified exchange-traded funds.

    While you make contributions and monitor your account based on your goals and time horizon, Schwab Intelligent Portfolios rebalances your portfolio to keep your allocation on track, and if you maintain at least $50,000 in your account, you can also elect to have tax-loss harvesting. Getting started is the most important step.




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