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Should You Use a Traditional or Roth IRA?

Should You Use a Traditional or Roth IRA?

May 03, 2016
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So you’ve left your job and you’ve decided to bring your 401(k) account with you by rolling it into an IRA (Individual Retirement Account). You don’t want that old company having any more control over your money than you want it having control over you. As you and your money both move on to greener pastures, you have an important decision to make: what kind of IRA are you going to roll your money into? There are two kinds of IRAs available; traditional and Roth.

Benefits of a Traditional IRA

Prior to 1997, there was only one kind of IRA, which is now referred to as a traditional IRA. It is a tax-deferred retirement account, meaning that is funded with pre-tax money and the taxes are paid when the money is withdrawn in retirement. This is a great benefit because you have more money available to invest if you don’t have to pay taxes out of it first. Also, people often find themselves in lower tax brackets in retirement, so you have to pay less in taxes than you would have originally.

IRAs can be invested in just about everything except life insurance or collectibles, so it is easy to make a good return on your money. Investors with experience in real estate can even use their money to buy real estate through a self-directed IRA. Also, unlike employer-sponsored retirement plans, with an IRA you are the complete owner and the plan is in no way tied to your employment. You can change jobs as frequently as you want and it does not impact your account or your ability to contribute to it (as long as you have earned income). You can even withdraw money penalty-free before age 59 ½ if it is for a qualified first-time home purchase or education expenses.

Benefits of a Roth IRA

Out of the Taxpayer Relief Act of 1997, a new kind of IRA was born, named after Senator William Roth of Delaware who was the chief legislative sponsor of the act. Roth IRAs differ from traditional ones in a few key ways. The biggest difference is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front. They key, though, that makes Roths so popular, is that you don’t have to pay taxes on any of the growth. Everything generated by compounding interest is yours, and the government doesn’t take any of it.

Roths also differ from traditional IRAs in that there are no required minimum distributions. So, you can leave your money in the account to grow for perpetuity, instead of being required to start taking withdrawals (and stop contributions) at age 70 ½ like with a traditional account. Some people even utilize this aspect of Roth IRAs as a way to provide tax-free income for their grandchildren and future generations. In addition to the traditional IRA’s allowances for special withdrawals, contributions (not growth) can be taken out at any time for any reason without penalty.

There are income limitations on who is allowed to open a Roth IRA. However, anyone can convert a traditional IRA into a Roth through a “backdoor conversion.”

Roth Rollover Considerations

Because of the different tax treatment of the two types of IRAs, there are tax consequences depending on the type of account you roll your 401(k) into. A normal 401(k) can be rolled into a traditional IRA without paying taxes. A Roth 401(k) can be rolled into a Roth IRA without paying taxes. However, to roll a normal 401(k) into a Roth IRA creates a tax liability. Since your 401(k) is pre-tax and a Roth IRA is after tax, you will have to pay ordinary income taxes on the money to move it from one to the other. And you are not able to pay the taxes out of the account itself, or that is considered a distribution and subject to penalty. In order to roll a normal 401(k) into a Roth IRA, you need to have sufficient money saved elsewhere to cover the tax bill.

One final thing you need to be careful of when rolling over 401(k) funds into an IRA is how they are rolled over; whether the money is sent to you or directly to your IRA custodian. If your old 401(k) plan writes a check to you, they are required to withhold 20% for the IRS. However, if you don’t deposit the full original amount into an IRA within 60 days it will be considered a withdrawal and you will be penalized. For example, you have a $10,000 401(k) that you want to roll over. Your previous employer writes you a check for $8,000 because they are required to withhold $2,000, or 20%. You, however, are required to deposit $10,000 into your new IRA in order to avoid the penalty, so you have to find the remaining $2,000 somewhere else in order to complete the transaction. It is much easier to do a direct transfer, or trustee-to-trustee transfer, where your previous employer sends the money directly to the IRA custodian and nothing is withheld for taxes.

Which IRA is Better for You?

Considering the differing tax treatment, a Roth IRA is typically better for younger people who have more time to save and, therefore, take advantage of compounding interest. If you are nearing retirement, and will be needing the money early in retirement, you may be better off with a traditional IRA. Many people choose a Roth regardless of their age so that they won’t be required to take distributions and they can leave the money to their families. If you make too much money to be eligible for a tax deduction for a traditional IRA, you would be better off with a Roth, though you would have to do a “backdoor” conversion to do so.   

The best kind of IRA for you to roll your old 401(k) into depends on your unique situation and preferences. When making big financial decisions like this, it is always wise to talk to an experienced professional who can help you understand your options and the implications of different choices. If you have an old 401(k) that you’re looking into rolling into an IRA, give us a call at 909-981-1720 and I can help you decide the best move for you.

About Philip

Philip A. Board MSFS, CFS, is a retirement planning specialist and the founder of 1on1financial, an independent comprehensive investment firm serving individuals and businesses near Upland, California. Through educational workshops and a non-sales environment, 1on1financial specializes in working with employees of Southern California Edison, UPS, Esri and Verizon.