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A Roth IRA offers tax-free withdrawals, but it’s not always the best choice. Learn about three situations where opting for a traditional IRA makes sense.
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There are plenty of reasons a Roth IRA is attractive to investors. You get tax-free distributions in retirement, which is a pretty sweet perk, even though you don’t get to deduct your contributions on your taxes. You’ll also avoid taxes and penalties if you withdraw your contributions (but not the investment earnings) at any time.
The traditional IRA has a lot less luster for most people. Sure, some people can deduct their contributions, though withdrawals are taxed as regular income. But the tax-free retirement income coupled with the additional flexibility make the Roth IRA more appealing to many retirement savers.
Still, there are a few scenarios where the traditional IRA makes sense. Here are three times you should consider a traditional IRA over a Roth IRA.
1. You want to reduce your upfront tax bill
As I mentioned earlier, you don’t get to deduct your Roth IRA contributions for tax purposes. But depending on your income, filing status, and whether you or your spouse is covered by a retirement plan at work, you may be able to deduct your full traditional IRA contribution.
Which option yields the better tax savings? It’s impossible to know unless you have a crystal ball.
Younger investors are often better off choosing the Roth IRA, especially if their earnings are relatively low and they don’t have a large tax liability. Unlimited tax-free growth over decades is pretty tough to beat.
But someone nearing retirement has less time for their money to compound. That means growth is limited, as well. A traditional IRA is more likely to make sense for an older investor, particularly if they have a high income and are eligible to deduct contributions.
2. You’re rolling over a traditional 401(k)
If you leave your job, you may opt to do an IRA rollover. Essentially, you transfer your money from a 401(k) to an IRA and maintain its tax-advantaged status.
But if you have a traditional 401(k), you’ll want to roll it over into a traditional IRA. Though it’s possible to roll over a traditional 401(k) into a Roth IRA, you’d owe taxes on the entire amount you’ve rolled over. However, rolling over a Roth 401(k) to a Roth IRA won’t result in a tax bill.
The rules for rollovers can get complicated. If you have questions, be sure to contact your IRA broker.
3. You earn more than the Roth IRA income limits
Technically, you can only contribute to a Roth IRA if your income is below an annual limit. If your modified adjusted gross income exceeds the following thresholds, you’re ineligible to make a contribution in 2023:
$153,000 if you’re single, head of household, or married filing separately and you didn’t live with your spouse at all during the year. If your income is between $138,000 and $153,000, you can contribute a reduced amount.$228,000 if you’re married filing jointly or a qualifying widow(er). If your income is between $218,000 and $228,000, you can contribute a reduced amount.$10,000 if you’re married filing separately and lived with your spouse at any point during the year. If you have income for the year and it’s less than $10,000, you can contribute a reduced amount.
There is a workaround called a backdoor IRA, though. You fund a traditional IRA, then immediately convert it to a Roth IRA and pay the applicable taxes. The rules can get complex here too, so you may want to consult with a financial advisor.
But sticking with the traditional IRA will probably make sense if you plan to make withdrawals in the next five years. Due to the Roth IRA five-year rules, you’ll owe income taxes on any rolled over amount if you haven’t had the account open for five years.
Traditional IRA vs. Roth IRA: Which should I choose?
There’s no perfect answer to this question, but here are some factors to weigh in your decision:
Would you rather get a tax break now or later on? If you want to lower your taxable income now, the traditional IRA wins. If you’re willing to pass on a tax break now and get tax-free withdrawals later, choose the Roth IRA.Do you think you’ll need to access your IRA contributions? If you’re deciding which account to open and you don’t have much saved, consider sticking with the Roth IRA. You can withdraw the contributions if necessary without penalty, whereas any early withdrawals from a traditional IRA will usually result in taxes and a 10% penalty.Can you afford a big tax bill if you’re doing a rollover? If you’re considering rolling a traditional retirement account into a traditional IRA versus a Roth IRA, be prepared to pay taxes on the amount you roll over by tax day.
Choosing between a traditional IRA versus Roth IRA can have important tax consequences. But don’t get so hung up on the decision that you delay saving for retirement. You’re allowed to have both a traditional IRA and Roth IRA, so you’re not locked into one account forever. The best thing you can do is start investing ASAP, so that you can maximize the power of compounding.
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