Investments and earnings within the IRA are tax-deferred, but funds distributed after age 59½ are taxed at the account owner’s ordinary income tax rate.
Conversely, contributions to a Roth IRA are made after-tax and do not provide a tax deduction. However, investments and earnings within a Roth IRA are tax-free and funds distributed after age 59½ are tax-free and not taxed as ordinary income as long as the account has been established for at least five years.
Accounts with Different Tax Advantages Could Provide Benefits Now and During Retirement
“You can’t control market returns, and you can’t control tax law, but you can control how you use accounts that offer tax advantages—and good decisions about their use can add significantly to your bottom line,” says Matthew Kenigsberg, a senior vice president with Strategic Advisers, Inc. in a recent article from Fidelity Viewpoints.
As mentioned, the Traditional IRA and Roth IRA provide different tax advantages. If you and your financial professional decide having both accounts is right for you, the flexibility could potentially be beneficial now and in retirement. Here are three scenarios to consider.
1) Having both accounts may let you decide between tax-deferred or after-tax contributions and impact potential tax deductions.
Having both account options allows you to work with your advisor or tax professional to decide whether a tax-deferred or after-tax contribution makes more sense in a particular year.
Additionally, your income levels may change as you move through your career. In past years, you may have fallen under the MAGI limits and qualified for a full or partial deduction on Traditional IRA contributions. But in years where a full or partial tax deduction is unavailable, investors may be less inclined to contribute funds with no tax advantage, knowing those funds will also be taxed when withdrawn from the account down the road.
It’s important to note that the IRA contribution limits set by the IRS each year apply to all IRAs an individual may have. For the 2020 tax year, the maximum contribution limit is $6,000 (or $7,000 if over 50). That’s the limit on what can be contributed between both a Traditional and a Roth IRA in a given year. However, it may be possible to split contributions between the two accounts – providing the flexibility and control for you to decide what’s best each year.
2) Having both accounts may provide flexibility when planning and managing your investment portfolio.
Which account is best for growth or value stocks? Should income-producing assets be held in a Traditional or Roth? What about REITs, rental properties, notes or other alternative investments?
These are questions for your advisor or financial professional, but having both a Traditional and a Roth IRA arms you and your advisor with options.
3) Having both accounts may provide tax flexibility during retirement when withdrawing funds.
After age 59½, it’s possible to withdraw funds from both Traditional and Roth IRAs without penalty (assuming the Roth IRA has been established for at least five years). After years of tax-advantaged growth inside the IRA, taxes are once again front-and-center in the distribution phase.
Distributions from a Traditional IRA are considered ordinary income (thus adding the amount you distribute to your modified adjusted gross income (MAGI) levels for that year) and are taxed at your ordinary income tax rate. Roth IRA distributions, on the other hand, are tax-free.
Due to its complexity, you should work closely with your financial advisor or tax professional when planning IRA distributions. However, those with both Traditional and Roth accounts may have added flexibility and can elect how much, when, and from which account they plan to distribute funds.
When the account holder reaches age 72, required minimum distributions (RMDs) begin for Traditional IRAs. A Roth IRA doesn’t have that requirement. Having both account types could provide options and flexibility during this phase as well.
Finally, since the Roth IRA is not subject to RMDs, it may be possible to pass down a Roth IRA (and all cash and assets held in the account) to a beneficiary when the account owner passes. The beneficiary can maintain the tax-free account (for up to 10 years if the beneficiary is not the spouse) and continue investing or may immediately distribute cash and assets tax-free.
As you’ve read, it’s possible to have both a Traditional IRA and a Roth IRA and there could be potential benefits to having both. Since everyone’s situation is unique, it’s important to consult with your financial advisor, CPA or tax professional before making any financial decisions.
Download the Traditional & Roth IRA Comparison infographic for a handy resource detailing features of each account.
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