Retirement Planning: Roth vs Traditional IRA

Key Summary:

• Traditional IRAs can offer tax benefits today, but Roth IRAs might provide the best long-term tax benefits.

• IRA required minimum distribution (RMD) taxability can lead to inflexibility during retirement, often making a Roth IRA the more attractive option.

• While a Traditional IRA can be rolled over into a Roth IRA, weighing the near-term taxability with the long-term benefits is crucial.

Choosing between a Roth IRA and a Traditional IRA often boils down to which retirement account provides the largest benefits during retirement. Current IRS tax laws can complicate the choice, especially if your marginal tax bracket is expected to change significantly, but forecasting tax benefits can prove difficult at best. For these reasons, we believe a Roth IRA is generally a better choice for most individuals. We provide some benefits for both IRAs below to help you decide what retirement plan might be right for you.

Traditional IRA vs Roth IRA

Traditional IRA contributions are generally tax deductible (subject to IRS limitations) and earnings growth is tax deferred. However, withdrawals are taxable, and IRS required minimum distributions (RMD) rules can limit flexibility for tax, retirement and estate planning. Since Traditional IRA withdrawals and RMDs are taxable, retirees often find their taxable income and marginal tax rates higher than expected.

While Roth IRA contributions are not tax deductible, the benefits are that earnings and gains are nontaxable, and most withdrawals are tax free. Also, Roth IRAs are not subject to IRS RMD rules, providing significant flexibility for tax, retirement and estate planning. 

Why a Roth IRA might be better: 

Roth IRA contributions are made with current after-tax dollars, but earnings and gains are nontaxable, and eligible withdrawals are tax-free. Paying taxes upfront can provide significant tax savings during retirement, allowing retirees the freedom to use a Roth IRA like a checking or savings account. Importantly, eligible withdrawals do not increase adjusted gross income or taxable income which is often important factor affecting tax deductions and government benefits during retirement. 

Why a Traditional IRA might be better: 

Contributions to a Traditional IRA are tax deductible (subject to IRS limitations) and earnings are tax-deferred until future withdrawals, which can provide current tax benefits. If your near-term marginal tax rates are higher than what is expected during retirement, you could benefit from the difference in tax rates.  

The verdict: 

Although individual tax situations vary, if you meet the eligibility rules, contributing to a Roth IRA over a Traditional IRA generally makes the most sense because it provides a tax-free source of income during retirement that will not adversely impact your future taxes. Lastly, a Traditional IRA can be rolled over into a Roth IRA at any time, which can be a wise choice for some individuals. However, income taxes must be paid on a portion of, or all the rollover balance, making it unattractive during years with high taxable income. 

Key Takeaways:

• A 529 plan is a tax-advantaged savings account designed to help families save for qualified education expenses, including college, K-12 tuition, and certain post-secondary training programs. 
• Post-contribution earnings are tax-free at the federal and state level.
• While 529 contributions are not tax deductible for federal purposes, some states do offer tax deductions for contributions. 
• Qualified withdrawals are tax-free at both federal and state levels when used for eligible educational expenses, such as tuition, books, and room and board. 
• Unused 529 funds can be rolled over into a Roth IRA (up to $35,000 lifetime) under certain conditions, avoiding taxes and penalties on closing withdrawals.

Introduction to 529 plans

The unrelenting rise in education costs in the US since the 1980s has created an affordability and accessibility problem for most American families. To help address the problem, in 1996 internal revenue code section 529 authorized US states to establish “qualified tuition programs” (QTPs), now called 529 plans, to help families save for future education expenses. The benefits of 529 plans have improved significantly since their introduction including tax-free withdrawals on qualified spending, portability between beneficiaries, and more recently the ability to rollover unused funds to a Roth IRA account. 

Parents, grandparents, other relatives and even certain trusts can own and contribute to a 529 plan in the name of a beneficiary. All 529 plans are state sponsored, so annual and total contribution limits vary.

Each client’s tax situation and education savings goals are different, so creating a 529 plan may not be suitable for you and your family. The following paragraphs provide some helpful information to consider in deciding whether a 529 plan may be right for you. 

Earnings are non-taxable

Contributions are made on an after-tax basis, so they are not federally tax deductible. However, all post-contribution earnings (including growth in investments within the 529 plan account) are tax-free at the federal and state level. Typically, you can contribute a maximum of $19,000 per beneficiary ($38,000 if married filing jointly) without reducing your lifetime exclusion. You may also choose to contribute $95,000 ($190,000 if married filing jointly) in a single year and treat it as a gift occurring over a 5-year period.

Qualified education spending is tax-free

Qualified withdrawals from a 529 plan are tax free at the federal and state level if used to pay for a beneficiary’s qualified educational expenses at eligible institutions. Qualified expenses include tuition, room and board, enrollment fees, books and equipment, among other costs. Annual withdrawals for beneficiaries are generally unlimited for post-secondary education but are capped at $20,000 per year for K-12 tuition. 

Additional state tax benefits for contributions

While California does not allow a tax deduction for contributions to 529 accounts, certain states do. Residents of eligible states can get an added benefit of an up-front state level tax deduction or tax credit, along with state and federal tax-free account growth which can significantly reduce the after-tax cost of education. 

Unused 529 balances can now be rolled over into a Roth IRA

Recent changes to 529 plan rules now allow for plan owners to rollover unused balances into a Roth IRA up $35,000 ($7,000 per year for 5 years) without incurring the unqualified withdrawal penalty or generating taxable income. Additional restrictions apply, but today’s 529 plans offer significantly more eligible spending options and reduce the cost and worry of overinvesting in 529 plans. Prior to the added Roth IRA option, restrictions left account owners with limited choices for unused 529 plan balances: either transfer to a new beneficiary or generate a taxable distribution to the account owner along with a 10% federal withdrawal penalty.