Which Type of Individual Retirement Account Is Right For Me?
November 15, 2023
When it comes to investing money it’s often overwhelming with how many factors need to
be taken into consideration. Investors need to decide what funds to buy, how much risk to take, what sectors to invest in, how much to invest each year, etc. These are questions we hear all the time in the investment business.
In my opinion, one of the most overlooked investment questions is WHERE should I invest my money. I’m not referring to a certain website or any specific stocks, but rather what type of accounts you are using to invest your money. There are non-retirement accounts, traditional IRA’s, Roth IRA’s, employee sponsored plans, SEP IRA’s, and many more. For the sake of brevity, the rest of this article will focus on two types of accounts. Roth accounts, and traditional retirement accounts.
Many employers offer both traditional and Roth options within their employer sponsored plans. There are also Roth IRA’s and traditional IRA’s that you can choose between. It’s important to understand the difference between employee sponsored plans and individual retirement accounts. Individual retirement accounts (IRA’s) belong to you and only you. They are not tied to your employer or any other individual. Employee sponsored plans such as 401K’s and 403B’s are not IRA’s and have a different set of rules, confusing right?
Many employers offer both traditional and Roth options within their employer sponsored plans.
IRA’s and employee sponsored plans are subject to different maximum contributions and income limits. In 2024 the IRA maximum contribution is $7,000, or $8,000 if you are 50 years old or older by the end of the year. This applies to both Roth IRA’s and traditional IRA’s. The maximum 2024 contribution for 401K’s, 403B’s, and most 457 plans is $23,000. You can also contribute an additional $7,500 each year to these plans if you’re 50 or older.
In Roth IRA’s, single filers must have a modified adjusted gross income (MAGI) of less than $146,000, and joint filers must have a MAGI of less than $230,000 to be eligible to contribute. Employer sponsored Roth accounts do NOT have the same limit. Even if you are over that income limit, you can still contribute to your employers Roth plan, just not a Roth IRA.
There is no income limit for Traditional IRA’s, however if you choose this type of account it’s important to consult a tax professional because your contributions may not be fully deductible if you or your spouse are covered by an employer-sponsored retirement plan.
When it comes to which accounts you use, the choice is yours. So which option should you go with, Roth or traditional? The unfortunate answer is, it depends. I’ll try to break down as many deciding factors as I can.
It’s important to know the main difference between these two accounts. Traditional accounts are invested pre-tax, which means that taxes aren’t taken out on the front end, and when you pull those dollars out in the future they’ll be taxed as ordinary income. Roth accounts are post-tax, meaning the money you put into your Roth has already been taxed. This means that when you pull money out of this account, you can withdraw it tax free. Both accounts grow tax free, meaning you don’t pay any capital gains. These rules are true for both IRA’s and employer sponsored plans.
The general guideline for which type of account to use is, "if you think your tax bracket will be higher when you retire than it is today, you may want to consider a Roth IRA."
The general guideline for which type of account to use is, “if you think your tax bracket will be higher when you retire than it is today, you may want to consider a Roth IRA”. While this sounds like a pretty straightforward answer, there are a number of additional things to consider.
How long do you have until retirement: This is a huge factor, here’s why. Say over your working career, you put $500,000 into your retirement account. In a Roth IRA, you pay income tax on $500,000, and you’ll pay that upfront with each contribution. If you invest $500,000 in a traditional retirement account, it’s uncertain how much you’ll pay in taxes. If the account tripled in size in each of these examples you are now paying taxes on $1,500,000 in a traditional account and you’re only paying taxes on the original $500,000 in a Roth account. While this is a big difference when investing long term, traditional retirement accounts often make more sense when investing short term. If you’re one year away from retirement and you know your taxable income will go down, it could be a no brainer to invest in a traditional account. GENERALLY the longer you have to invest the money, the more attractive Roth accounts are.
How is your portfolio currently balanced: If 100% of your assets are invested in traditional accounts, it might make sense to invest in a Roth account. If you are 100% invested in Roth accounts, it might make sense to look into a traditional account. Having a balance of both can be a good idea especially as you approach retirement. In retirement, you can pull money out of each of these accounts, which if done strategically can lower your tax burden in retirement.
Everyone has different life plans, current portfolio's, and time horizon until they withdraw retirement dollars.
Taxes will change in the future: One thing we can always count on is that taxes will change. They will go up and down throughout the course of each of our lives. So how do you plan for this? By incorporating tax free dollars into your portfolio. If you have a Roth account, you know that no matter what taxes are down the line, you will be able to pull every dollar out of that account without the government laying a hand on it. The same goes for the inverse. If taxes drop to an all time low level, it’d be pretty useful to have traditional dollars to withdraw and take advantage of the low tax rate.
Like I said earlier in this article, there is no set in stone answer. Everyone has different life plans, current portfolio’s, and time horizon until they withdraw retirement dollars. I hope that this helped give you a good idea on how each of these accounts function and can be beneficial in your portfolio. As always, feel free to reach out to us with questions or if you are curious on how these rules apply to your specific portfolio.
QUINN DAVIS | Financial Advisor
RIVERFRONT CAPITAL STRATEGIES
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
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