Roth vs. Regular IRA

A good buddy of mine called me the other night and asked me if he should go with a Roth or regular IRA. If this was just anyone, I wouldn’t have thought much of it. But it wasn’t. My buddy has been working in financial services for ten years; he has been an institutional trader for a billion-dollar brokerage firm. And yet he still hadn’t mastered the nuances of the Roth IRA.

So I extrapolated and concluded that if a guy like that was asking for some guidance on the Roth vs. regular IRA conversation, a lot of other people are probably looking for the same. And since it’s tax season, this is the perfect time to figure out which of these two accounts will best serve your needs.

Let’s go ahead and take a closer look at the differences between a Roth and regular IRA.

Contribution Limits

At the very top, annual contribution limits for these two accounts are exactly the same at 5K. That goes up to 5.5K at age 55 under “catch up” clauses for individuals getting close to retirement, but overall, no real difference in contribution limits between a Roth and regular IRA.

Income Restrictions

This is the first place where the Roth and IRA part ways. A Roth IRA is only available to individuals making 95K or less or households with an income of less than 150K. The IRA on the other hand, has no income restrictions for individuals or households. Score a few points for the IRA in this category.

Taxable Income

This is the biggest difference between the Roth and regular IRA.

Contributions to the regular IRA are tax deductible. That means if you earn 95K, but make a 5K contribution to your IRA, your taxable income will fall to 90K. At an income tax rate of 25%, that’s an immediate 1.25K saved on taxes. Bigger picture, reducing your taxable income also gives you a shot at falling into a lower tax bracket in a progressive tax system and lowering your tax bill even further.

But unlike the IRA, you pay regular income taxes on your contributions to a Roth. But longer term, where an IRA owner pays taxes on withdrawals, the Roth crowd has already covered its tax obligations.  That basically boils down to paying taxes on contributions to a Roth and paying taxes on withdrawals with an IRA. Either way, both accounts are great for helping investors avoid double taxation.

Tax Bracketology

Here’s another nuance between the Roth and IRA. Generally speaking, most people make more money as they get older, pushing them into a higher tax bracket later in their career. So electing to go with a Roth IRA means you are assuming a tax liability earlier in your career when you fall into a lower tax bracket. The difference between paying a 15% effective tax rate vs. 21% can have a big impact on the life and duration of your retirement savings.

Withdrawals

You’ll generally see the same rules for the Roth and regular IRA, where qualified withdrawals start at age 59.5. Mandatory withdrawals don’t start until 70.5. Certain hardship provisions for early withdrawals exist for both accounts, but beyond those criteria, a 10% penalty is applied.

The Big Picture

So in a nutshell, the Roth and regular IRA actually look a lot alike. The biggest difference is the timing of when you pay taxes. On the IRA, you pay taxes on withdrawals, but with the Roth, you pay taxes on your contributions. There really is no right or wrong answer, just a matter of finding the best fit for your unique investment needs.

MONEY MATTERS is a weekly column on the Retail Minded Blog that is contributed by Michael Vodicka, founder of boutique financial consulting firm the Vodicka Group. MONEY MATTERS is Retail Minded’s way of supporting independent store owners with all their financial concerns, real life needs and everyday issues both in and out of their  stores. You can find MONEY MATTERS every Wednesday on RetailMinded.com as well as in each issue of Retail Minded Magazine.