Traditional IRAs vs. Roth IRAs
There are three main distinctions between a traditional IRA and a Roth IRA: eligibility, contributions and withdrawal requirements.
- Eligibility. With a Roth IRA, there is an income threshold (based on tax filing status) you must remain under to even be eligible. There are no income-based eligibility restrictions with a traditional IRA. (Note: If your income makes you ineligible to open a Roth IRA, you still have the option of opening a traditional IRA and then converting to a Roth.)
- Contributions. For those whose income falls below a specified threshold (based on tax filing status and employer retirement plan coverage), traditional IRAs offer an immediate tax break on contributions, allowing you to lower your taxable income for the year in which you contribute. Roth IRAs do not offer an upfront tax break.
- Withdrawals. You can withdraw from a traditional IRA after age 59½ without penalty, but you pay current tax rates on the withdrawal. In addition, traditional IRAs are subject to required minimum distributions (RMDs), so you are obliged to start making withdrawals at age 72. For a Roth IRA, withdrawals after age 59½ are tax-free, so long as you’ve had the account for at least five years. Unlike the traditional IRA, there are no RMDs for Roth IRAs.
Simply put, a traditional IRA generally offers its tax advantages upfront, giving you a tax break on your contributions. The Roth IRA offers its tax advantages on the distributions, letting you withdraw funds tax-free. (See Table 1 for a more complete snapshot of the differences between the two accounts.) Many people choose to open a traditional IRA for that exact reason: They expect they’ll be in a higher tax bracket when they’re working than when they’re retired, and they’d therefore receive a greater tax benefit upfront. That said, there can be benefits to converting your traditional IRA to a Roth IRA, depending on your circumstances.
|This year or in the future?||This year, generally||In the future|
|Funding source||Pre- or after-tax dollars||After-tax dollars only|
|Maximum annual contribution||$6,000||$6,000|
|Over-50 catch-up contribution||$1,000||$1,000|
|Eligibility||Anyone with earned income||Anyone with earned income below a certain threshold, based on tax status|
|Penalty-free?||Yes, after age 59½||Yes, after five years and age 59½|
|Tax-free?||No, taxed as ordinary income||Yes, after five years and age 59½|
|Required minimum distributions||Yes, starting at age 72*||No|
Table 1. Snapshot: Traditional IRA vs. Roth IRA. All data are for 2020. *Under the CARES Act, RMDs have been waived for 2020.
Should You Convert Your Traditional IRA to a Roth IRA?
One of the most common reasons to convert your traditional IRA to a Roth is if you determine your tax bracket in retirement will be higher than your current tax rate – say, if you’ve accumulated significant savings in your retirement accounts or achieve your top earnings later in your career. Other reasons to consider a Roth conversion include:
- Additional flexibility in retirement. Because Roth IRAs allow you to withdraw funds without increasing your tax burden and have no RMD obligations, they are less restrictive and can give you additional financial choices – including the option of staying invested in the stock market for a longer period of time. They might also provide some tax planning benefits if your other retirement assets are taxed when withdrawn.
- Lower IRMAA rates. If you are enrolled in Medicare Part B or D and your modified adjusted gross income is above a certain threshold, you would pay a surcharge on top of your monthly premium. That Income-Related Monthly Adjustment Amount could cost thousands of dollars per year. While withdrawals from a traditional IRA add to your MAGI, potentially bumping up your IRMAA surcharge, withdrawals from a Roth IRA do not.
- A lower tax burden for your heirs. Before the SECURE Act, if you were to leave a traditional IRA for an heir, they could manage the tax hit by taking small distributions from it over the course of their lifetime. Now, they only have 10 years to deplete it in most cases, and those larger distributions could move them to a higher tax bracket. By converting to a Roth, your heir would still have to deplete it in 10 years, but those distributions would be tax-free.
That said, converting a traditional IRA to a Roth IRA might not be right for everyone in every situation. For example, if you’re nearing retirement and using your traditional IRA distributions to pay for living expenses, you might not have time to recoup what you would pay in additional taxes with a conversion. A Roth conversion might also not be necessary if you’re using a Qualified Charitable Distribution to meet your traditional IRA’s RMD requirements. The appropriateness of a Roth conversion, much like the decision to open a traditional or Roth IRA, will depend on your specific financial circumstances and goals.
Finally, there are two important factors to keep in mind if you decide to make the conversion: (1) you must pay income taxes on any pre-tax funds you convert in the year of the conversion, and (2) you can’t change your mind once you convert – a provision in the Tax Cuts and Jobs Act prevents you from recharacterizing your new Roth IRA back to a traditional IRA.
Given all the changes, this promises to be a complicated tax year for many people. While Baird does not offer tax or legal advice, our Financial Advisors regularly work with clients’ attorneys and tax professionals to help ensure that all aspects of wealth management are addressed, and can help you sort out which strategies are right for you. For additional insight into the tax implications of today’s IRAs – as well as other end-of-year tax tips – be sure check out Tax Strategies for 2020 from Baird’s Wealth Solutions Group.
With a little planning, your HSA can do a lot more than fund short-term healthcare expenses.