Today’s question comes from another dear friend of mine who left the workforce for a few years to pursue a graduate degree. She has some funds in a 401(k) from her previous employer and is trying to figure out if it is better to rollover her funds into a Roth IRA or a traditional IRA.
She asks: “What are the pros and cons of Roth vs normal IRA? Is it worth it to pay out taxes now, especially since I expect I’ll be over the limit and unable to contribute once I finish grad school in 2 years? And if it’s as good as it sounds, shouldn’t every 20-something making much less now than we will in the future be taking advantage of it?”
The short answer: Yes!
I have always been a huge fan of the Roth IRA. It is my personal opinion that it is the best investment tool available and everyone who can should take advantage of it. I personally have maxed out my Roth IRA since I began working, and I would encourage everyone who is eligible to invest as much as they can in a Roth IRA.
What is an IRA?
An IRA is an Individual Retirement Account. Unlike a company-sponsored 401(k) or equivalent, an IRA is something that you can open and maintain completely on your own. Like other investment accounts, an IRA is not in and of itself an investment, it is simply one type of account through which you can invest. You can open an IRA at any number of financial institutions, including traditional banks and investment banks both online and off. Once you have an IRA and fund it by putting money into it, you can then invest that money in any number of investments, from CDs to stocks, bonds to mutual funds.
IRAs come in two flavors: traditional and Roth. The key different between these two types of IRAs is in the tax treatment. A traditional IRA is funded with pre-tax income. Yearly taxes on earning are deferred and are only paid when you withdraw the funds, which are treated as ordinary income, in retirement. A Roth IRA is funded with post-tax income and is able to grow tax free, meaning that no taxes are due when you withdraw funds.
There are a few other differences between traditional and Roth IRAs.
- Income limits. You may only contribute to a Roth IRA if your income falls below certain limits, which vary depending on your age and filing status. Traditional IRAs have no income limits.
- Age limits. You can contribute to a Roth IRA at any age (even in retirement) but cannot contribute to a traditional IRA after age 70.5.
- Distributions. Traditional IRAs have required minimum distributions starting at age 70.5, whereas Roth IRAs have no required minimum distributions.
There are also many similarities between traditional and Roth IRAs.
- Financial institutions. Both can be held at most financial institutions.
- Contribution limits. Both have a combined yearly contribution limit (currently at $5,500). This means that you can contribute a maximum of $5,500 to all IRAs (not including rollovers), not $5,500 to each a traditional and Roth IRA.
- Withdrawal penalties. Both have penalties for early withdrawals, although for a Roth IRA you may withdraw you contributions penalty free in certain qualified circumstances, such as for the purchase of a first home or for educational expenses. Note that this only applies to contributions, not income generated from those contributions (i.e. if you invest $1,000 and five years later it is worth $1,100, you can withdraw the $1,000 penalty free but not the $100 that you’ve earned on that money).
So which is better, a Roth IRA or a traditional IRA?
If you are eligible for an IRA, I think that in almost all cases a Roth IRA is the better choice. The fact that you can pay taxes now and never again in the future is HUGE. This is especially true if you are young and expect your income to rise in the future. If your income is low, you’ll be in a low tax bracket and may not have to pay much in taxes to begin with. If you expect your income to rise in the future, there is a huge benefit to paying taxes now instead of when you make withdrawals in retirement.
It also doesn’t hurt that tax rates are still pretty low compared to historical averages. Who knows what tax rates will do in the future, but if you’ve got your money locked in to a tax-free vehicle, you’re likely to be in good shape no matter what happens down the line. One thing that I have worried about from time to time is the possibility that the tax-advantaged status of Roth IRAs might change in the future. I’ve researched this quite a bit and while anything is possible, I’ve seen no historical evidence to indicate that the government might take this advantage away in the future.
Another reason that Roth IRAs are particularly awesome for young people is the income limit. Chances are that when you’re just starting out, your income will be well below the limit. Take advantage of this! Hopefully your income will go up over time and eventually you’ll become ineligible for a Roth IRA (this is a pretty good problem to have!). If you contribute now, you’re paying low taxes on your low income, giving yourself a really really long time for that money to grow, and getting your money in to a tax-advantaged account while you can. It’s a win-win-win!
Traditional IRAs are good, too
If you’re not eligible for a Roth IRA, that doesn’t mean that you shouldn’t contribute to an IRA at all. Traditional IRAs are also a great tool, and I will always argue that saving something is better than saving nothing!
Another thing to consider if you earn too much money to be eligible for a Roth IRA is a Roth IRA conversion, sometimes called a “backdoor” Roth IRA. This is when you fund a traditional IRA and then roll it over into a Roth IRA. There are no income limits for rollover Roth IRAs, so this is completely legal, although it may have substantial tax implications due to the different ways that Roth and traditional IRAs are taxed.
What should my friend do?
Based on my friend’s specific circumstances, it sounds like a Roth IRA conversion is definitely the right choice. She is making a relatively low salary right now, which means that she is paying a very low tax rate. She’ll have to pay some taxes to make the conversion from a 401(k) to a Roth IRA, but it will be less now than it would be at a time when she is working and making her full salary. The Roth will also give her a lot more flexibility with her money, allowing her to use some of her contributions for a down payment on a home or another qualified expense in the future.
I would also argue that, if the income is available, she should take advantage of being under the Roth IRA income limit while in school to make additional contributions to her Roth IRA. She’ll likely become ineligible in the future, and the benefits of having more money for retirement growing tax free are huge.
What did I do?
Funnily enough, I’ve found myself in nearly this exact situation in recent weeks. As I’ve mentioned before, I recently left my job of five years and have started at a new company. This left me with both a state pension payout and 457 (public sector equivalent to a 401(k)) to deal with. So what did I do with my money?
I didn’t follow my own advice! As much as I love Roth IRAs, I knew that a Roth IRA conversion was not the right choice in my situation. Unlike my friend, who is rolling over funds at a time of relatively low income, I am rolling over funds at a time of my highest income to date. Because of this, the tax implications of transferring my money into a Roth IRA instead of a traditional IRA were too steep. I elected to transfer my funds into a traditional IRA so that I can avoid paying taxes.
I’m still below the Roth IRA income limit, and I have already fully funded my Roth IRA for the year, so I’m not abandoning my Roth altogether. For me, at this time in my life, a Roth IRA conversion simply wasn’t the right choice. I’m sharing this to illustrate that all of this is very dependent on circumstances, and there is no one-size-fits-all answer when it comes to personal finance.
So what do you think – Roth or traditional IRA?