5 Times It’s Smarter to Choose a Traditional IRA Instead of a Roth

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We could practically write a sonnet about all the reasons we love Roth IRAs, but traditional IRAs tend to get a lot less attention.

The traditional IRA is the original individual retirement account. It’s been around since 1975, long before its more glamorous cousin, the Roth IRA, showed up on the retirement scene in 1997.

So what is a traditional IRA? And when you’re deciding between a Roth IRA vs. traditional IRA, does a traditional IRA ever make sense?

What Is a Traditional IRA?

Like a Roth IRA, a traditional IRA is a retirement account that you open on your own, independently of your employer. It’s an option for people who don’t have a 401(k) plan through their job or those who want to save even more for retirement outside of their employer’s plan.

The key difference between the two: When you fund a traditional IRA, you’re allowed to deduct your contributions at tax time in most circumstances, which lowers your taxable income. That means you could wind up owing less on April 15, and you could even get a larger tax refund.

You don’t even need to itemize your deductions to take advantage. It’s what’s known as an above-the-line deduction, which means you can take it even if you opt to take the standard deduction when you file your taxes.

Your money grows on a tax-deferred basis. Then, you pay ordinary income taxes on it when you withdraw it in retirement.

With a Roth IRA, you don’t get to deduct your contributions, so funding one won’t help you land a fatter refund. But the real benefit is that your money also grows tax-deferred — and then it’s all yours when you retire, completely tax-free.

You choose your own investments when you open either type of retirement plan. Your investment options include:

For many beginning investors, a better option is to have a robo-advisor create a custom portfolio for you.

How Much Can I Contribute?

The traditional IRA contribution limits are the same as the Roth IRA limits. In 2020, you can contribute up to $6,000 a year to either account, or you can have both accounts and split your funds between the two. If you’re 50 or older, you’re allowed to make an extra catch-up contribution of $1,000.

Who Can Fund a Traditional IRA?

As long as you have earned income, there’s no age limit on contributions to a traditional IRA or a Roth IRA. Earned income sources include:

  • Salary
  • Hourly wages
  • Tips
  • Self-employment income
  • Bonuses

Social Security, investment income, alimony, child support and unemployment don’t count.

A Roth IRA has income limits, but you can contribute to a traditional IRA regardless of how much you earn.

Pro tip: A spousal IRA can help non-working spouses save for retirement. You can set it up as either a traditional or a Roth IRA.

When Can I Withdraw Money?

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You’ll owe income taxes plus a 10% penalty if you take money out of your traditional IRA before age 59 ½ in most circumstances.

If you think you may need to tap your money early, the traditional IRA is at a major disadvantage over a Roth IRA.

Roth IRA rules allow you to withdraw your contributions at any time without paying taxes or a penalty because you’ve already paid taxes on them. Only your earnings are subject to taxes and the 10% early withdrawal penalty. But with a traditional IRA, you’ll pay income taxes on any withdrawal because Uncle Sam hasn’t gotten his cut yet.

You may be able to avoid the additional 10% penalty on early withdrawals from a traditional IRA in a few situations, such as:

  • You’re withdrawing up to $10,000 for a home purchase. The IRS will allow you to withdraw up to $10,000 without penalty if you’re a first-time homebuyer — and you may qualify even if you’ve owned a home before. The IRS considers you a first-timer if neither you nor your spouse has owned a home in the past two years, though the $10,000 cap is a lifetime limit. Your spouse would be able to withdraw $10,000 from their IRA, as well.
  • You’re using the money for higher education expenses. You can withdraw any amount from a traditional IRA without penalty if you’re using it for higher education expenses like tuition, books and fees. You can use the money for your own education or on behalf of some relatives, such as your spouse, child or grandchild.
  • You have certain medical expenses. You can withdraw your money without penalty for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income or to pay for health insurance premiums for you and your family if you’ve been unemployed for at least 12 consecutive weeks.
  • You’re taking a coronavirus-related withdrawal. The CARES Act allows people affected by coronavirus to withdraw up to $100,000 penalty-free from a retirement account without penalty.

Remember: In any of the situations listed above, you’ll still owe income taxes on your traditional IRA withdrawal, but you’ll avoid the 10% penalty. If you’re taking a CARES Act withdrawal, you’ll be able to spread out the tax bill over three years.

Do I Have to Take Money Out of My Traditional IRA?

Yes. Unlike Roth IRAs, which you never have to touch in your lifetime, traditional IRAs have required minimum distributions, or RMDs. Once you turn 72, the IRS requires you to make withdrawals of a certain amount each year; the minimum distribution is determined by your life expectancy based on your age.

But wait! There’s an exception. The CARES Act rules for retirement waved RMDs for 2020 to give portfolios time to recover following the stock market crash. That means no matter how old you are, you don’t need to take a distribution in 2020.

In normal years, though, the penalty for not taking an RMD is severe: You’ll pay a penalty of 50% of the amount you were supposed to withdraw.

Traditional IRA Pros and Cons

OK, let’s recap. Here are the advantages and disadvantages of a traditional IRA.

Traditional IRA Pros

  • It’s a way to save for retirement outside of an employer’s retirement plan.
  • You get an up-front tax break, and your money grows tax-deferred.
  • You can contribute if your income is too high to fund a Roth IRA.
  • You can contribute at any age, so long as you have earned income.

Traditional IRA Cons

  • You’ll owe income taxes when you withdraw your money.
  • If you withdraw your money before age 59 1/2 , you’ll pay a 10% penalty in most circumstances.
  • Required minimum distributions begin at age 72, which is a disadvantage to those who want to pass the money down to their heirs.

5 Times a Traditional IRA Makes Sense Instead of a Roth

A Roth IRA is appealing because it offers a chance to build a tax-free nest egg while allowing easy withdrawals of your contributions any time. But there are some times when a traditional IRA makes more sense. You might want to consider a traditional IRA if:

1. You Want to Reduce Your Taxable Income

If you want to decrease your AGI for some reason — say, you’re hoping to maximize your kid’s financial aid package when they start college — contributing to a traditional IRA could be a good option. Roth IRA contributions won’t lower your AGI.

2. You Expect to Be in a Lower Income Bracket When You Retire

If you’re expecting to have a significantly lower income when you retire, a traditional IRA may make sense. You’ll get the tax break now and then you may pay less in taxes later if your income falls into lower tax brackets.

The flip side: If your income is a lot lower in retirement, the tax-free income from a Roth IRA could be way more valuable than the tax break you get now.

3. You’re Hedging Your Bets on Taxes

Retirement planning involves tons of guesswork. It’s hard to predict what your income will look like decades from now or what tax rates in general will look like.

You could hedge your bets by dividing your contributions between a traditional IRA and a Roth IRA. That way, you get part of the tax benefits now and a tax-free source of income in retirement.

4. You Earn Too Much to Contribute to a Roth IRA

Since a Roth IRA has income limits, you may have to opt for a traditional IRA if you’re a high earner.

In this case, you may still be able to fund a Roth IRA using what’s called a backdoor IRA. Basically, you open a traditional IRA and convert it to a Roth IRA. You pay taxes on the money, but you get the tax-free benefits later on.

Warning: Backdoor IRAs are extremely complicated and should be handled by an experienced CPA.

5. You’re Rolling Over Your 401(k)

When you leave your job, you may need to decide what to do with your 401(k). If you don’t want to keep it with your former employer, you’ll need to do a 401(k) rollover.

A lot of people roll their 401(k) into their new employer’s plan. But if you’re between jobs, pursuing full-time freelance work or don’t want to put the money in the new company’s 401(k) for whatever reason, an IRA rollover could be an option.

Rolling over your balance into a traditional IRA often makes most sense in this case. Sure, you could roll over your balance to a Roth IRA, but you’d owe taxes on it. Do you really want to get hit with a big tax bill after you’ve lost your job or taken a big risk by venturing out on your own?

Traditional IRA vs. Roth IRA: Which Do I Choose?

There’s no one-size fits all solution to this question. But it boils down to: Do I want to save money on taxes now, or do I want tax-free money when I retire?

The most important rule is to just start saving already. Whether you choose a traditional IRA, a Roth IRA or both, your retirement will be richer for it.

Robin Hartill is a certified financial planner and a senior editor at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]