Traditional and Roth IRAs offer different benefits – but both can make sense

Key takeaways

• Taxes are a key consideration in deciding between a Roth IRA and a traditional IRA.
• Flexibility may be a consideration as well: A Roth IRA allows you to withdraw your contributions anytime, with no taxes or penalties due.
• It may make sense to contribute to both types of IRAs if you are eligible, so you have tax-free and taxable options when you withdraw the money in retirement.
• To make the most of your IRA savings, invest the money for long-term growth.

You’re ready to save for retirement in an IRA. But wait, there are 2 types of IRAs—a traditional IRA and a Roth IRA. Which one should you choose? You may be able to contribute to both types. Here are some things to keep in mind as you decide which is the appropriate choice for you now.

First, the basics. Traditional and Roth IRAs are both types of tax-advantaged accounts designed to help people save for retirement. For 2019 and 2020, eligible taxpayers can contribute up to $6,000 (or up to the level of earned income, if lower) to a traditional IRA, or $7,000 if they have reached age 50.

The same amounts can be contributed to a Roth IRA, as long as your income (as defined by modified adjusted gross income, or MAGI) is not above the limits: The ability to contribute to a Roth IRA starts to phase out at $193,000 in 2019 and $196,000 in 2020, if you are married and file a joint return. If you are a single filer, the phase-out begins at $122,000 in 2019 and $124,000 in 2020.

There is an earned income requirement to contribute to an IRA. You, or your spouse, must have taxable earned income of at least your contribution amount.

Which kind of IRA?

With a traditional IRA, your contribution may reduce your taxable income and, in turn, your federal income taxes if you are eligible for the tax deduction.1 Earnings can grow tax-deferred until withdrawn, although if you make withdrawals before age 59½, you may incur both ordinary income taxes and a 10% penalty. (There are a handful of situations that may qualify for waiving the early withdrawal penalty.) After age 59½, you may make withdrawals of any amount without penalty, but federal and state taxes, if applicable, will apply. Starting in the year you reach age 72,2 you will need to begin taking at least the required minimum distributions (RMDs) and paying ordinary income taxes on the distribution amount.

To estimate your tax savings on a traditional IRA contribution, you’ll need your marginal tax rate. Then multiply it by the amount of money you contributed to your traditional IRA. That’s generally how much a traditional IRA may reduce your federal income tax. (Keep in mind that it’s an estimate. In some cases your contribution can reduce your marginal tax rate, so your federal tax savings might be smaller. On the other hand, you might also save on state income taxes.) For a hypothetical example, a person with a 25% marginal federal income tax rate would save $1,375 in taxes on a contribution of $5,500, if the person is eligible for a tax-deductible contribution to the IRA.

While everyone with earned income can contribute to a traditional IRA, if you and/or your spouse also have access to a workplace plan like a 401(k), your ability to deduct your traditional IRA contribution may be limited, so you may want to prioritize the workplace plan. The most common types of workplace plans, 401(k)s, 403(b)s, and 457s, allow participants to save more than 3 times the annual IRA contribution limit. Money saved in the traditional types of these accounts reduces your taxable income for the year. Saving first in the account that offers the biggest tax benefit could help you make the most of your savings.

With a Roth IRA, your contribution isn’t tax-deductible the year you make it, but your money can grow tax-free and your withdrawals are tax-free in retirement, provided that certain conditions are met.3 Eligibility to contribute to a Roth depends only on MAGI—a retirement plan at work for you or your spouse is not a factor. As long as your MAGI is beneath the annual limit, you can contribute to a Roth IRA.4

Earnings on those contributions (although not the contributions themselves) may be subject to both tax and early withdrawal penalties if withdrawn before the qualifying criteria are met.3 As with the traditional IRA, there are some circumstances that qualify for an exception to the 10% penalty—like buying a first home or paying qualified educational expenses. Because Roth contributions are made after taxes have been paid, you can withdraw your contributions anytime, with no taxes or penalties due.

Unlike traditional IRAs, Roth IRAs do not have RMDs (during the original owner’s life).

Spousal IRA

If your spouse doesn’t work, they can have a spousal IRA. This allows non-wage-earning spouses to contribute to their own traditional or Roth IRA, provided the other spouse is working and the couple files a joint federal income tax return. If the working spouse is covered by a retirement plan at work, deductibility of contributions to a spousal traditional IRA would be phased out at higher incomes.1 This means eligible married spouses can each contribute up to the contribution limit each year to their respective IRAs.5 Spousal IRAs are also eligible for a $1,000 catch-up contribution for those 50 and older.

Making a decision

But tax rates don’t tell the whole story. “How disciplined you are at saving can also play a role in which type of account may better help you prepare for retirement,” explains Ernest Shervani, vice president of investment and tax solutions at EXM Capital. Here’s why. Generally, pre-tax contributions to a traditional IRA can help lower your taxable income, if you are eligible, giving you more money in your pocket. These tax savings help improve your retirement picture only if you’re disciplined enough to save. If you tend to spend any money left at the end of the month, or any income tax refund, it’s not going to help your bottom line when you retire. Of course, on the other hand, the tax savings may provide an extra incentive to save now that Roth IRAs don’t offer.

With Roth IRA contributions, you pay taxes up front. But if you (like many people) tend to spend all your discretionary income, having less disposable income might be a good thing when it comes to your retirement savings.

“In a sense,” says Shervani, “switching from a traditional IRA to a Roth IRA forces you to save more for later by keeping less in your pocket now, assuming you keep making the same contribution.”

Roth IRAs have additional advantages that go beyond taxes. Because you don’t need to take RMDs with a Roth (during the life of the original owner) and because the assets in a Roth account can be bequeathed to your heirs income tax-free, Roth accounts can be a useful estate planning tool.

Not eligible to contribute to a Roth IRA because your income is too high? You can convert a traditional IRA to a Roth IRA, though you will need to pay taxes on the conversion. (If you’ve made nonqualified contributions and include them in your converted balance, they won’t be taxed.)

Having it both ways

It may be appropriate to contribute to both a traditional and a Roth IRA—if you can. Doing so will give you taxable and tax-free withdrawal options in retirement. Financial planners call this tax diversification, and it’s generally a smart strategy when you’re unsure what your tax picture will look like in retirement. (Remember, though, you can contribute only up to the contribution limit in any one year—so $6,000 in 2019 and 2020, plus $1,000 if you are age 50 or older—in total across all IRAs you own, whether traditional or Roth.)

For example, with a combination of traditional and Roth IRA savings, you could take distributions from your traditional IRA until you reach the top of your income tax bracket, and then withdraw whatever you need beyond that amount from a Roth IRA, which is tax-free, provided certain conditions are met.

On the other hand, taxes in retirement may not be the whole story. Reducing your current taxable income through traditional IRA contributions may also be advantageous for other reasons, such as qualifying for student financial aid.

There’s still one more tax benefit available to some taxpayers: the saver’s credit. The maximum credit available is $2,000. Eligibility is based on your adjusted gross income (AGI). Depending on your AGI, you could get a credit of up to 50% of your contribution to an IRA or workplace retirement plan. The amount of the credit goes down as income goes up, phasing out at $64,000 in 2019 and $65,000 in 2020 for joint filers.

Investing an IRA contribution

Many people make their IRA contribution just before the April tax deadline, and put it into a money market fund. Then they never go back and choose a growth-oriented investment. This is generally not ideal. One of the best ways to give the money a chance to grow over the long term is by having an age-appropriate level of diversified exposure to stocks—in the form of mutual funds, ETFs, and/or individual securities. Of course, that means getting used to riding the ups and downs of the market.

Consider this hypothetical projection: One $6,000 contribution could grow to approximately $64,000 in 35 years. For those age 50 or older, one $7,000 yearly contribution could grow to more than $74,700 in 35 years.6 (We used a hypothetical 7% long-term compounded annual rate of return and assumed the money stays invested the entire time. Investments that have the potential to return 7% annually are generally those that come with some risk, such as stocks.)

If the $6,000 amount seems daunting, even if you can put only $550 into an IRA and leave it there invested for 35 years, earning a hypothetical annual return of 7%, it could be worth nearly $5,900 in 35 years. Make that $550 contribution every year and it could be worth over $87,000 after 35 years, using a hypothetical annual rate of return of 7%. (Note: These examples do not take into account taxes, inflation, or fees.)

 

Next steps to consider

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We expect there will be a recession in the next decade, we have no idea when that will happen.

We expect that some of our investments won’t do well. we don’t know which ones. We forecast the weather will be sunny tomorrow.

There’s a huge difference between an expectation and a forecast in investing. An expectation is an high-probability acknowledgement of how things might happen. A forecast is a specific prediction. in investing, forecasts are dangerous. For example : the coronavirus.

Last week, Ray Dalio published a piece outlining what’s happened with past viruses throughout history ( from SARS to the Spanish flu ). We can expect China’s economy ( and many of the wonderful businesses that comprise it ) to recover. But we won’t even try to forecast when the worst is over. Those that make such forecasts are effectively gambling.

Similarly, if you’re thinking ” I expect the market to hit a correction in the next few months,” you’ll likely take actions in your portfolio to try to navigate around it. Those actions are the root of most bad investment decisions.

Don’t try to forecast things precisely in investing. instead, have expectations.

For instance, we expect Google to grow its earnings faster than the market over the next decade. We expect volatility along the way , and that’s okay.

Forecasted plans are overly precise and will be proven wrong with enough at-bats. Expectations , however help us navigate even the choppiest waters.

Nobody panics when things go according to plan.”

Heath Ledger (The Joker)

Happy Oscars Weekend

WEEKEND READS

Wealth is what you don’t spend (3 min read) https://www.collaborativefund.com/blog/gains/ “The world is filled with the financial equivalent of athletes who finish every workout with four Big Macs

The Next U.S President’s Impact on stock ( 5min Read).https://www.washingtonpost.com/business/economy/the-next-us-president-will-have-little-effect-on-the-stock-market-heres-why/2020/01/15/38ef35e0-37ad-11ea-bf30-ad313e4ec754_story. “There is no correlation between a successful candidate’s pro-business sentiments and subsequent market performance.”

Our Early Thinking on the coronavirus and pandemics ( 7min read). https://www.linkedin.com/pulse/our-early-thinking-coronavirus-pandemics-ray-dalio Bridgewater’s Ray Dalio on the coronavirus and its potential economic impact.

Michael Burry on the Financial Crisis ( 30 min video).https://www.youtube.com/watch?v=fx2ClTpnAAs. Throwback from the outsider who predicted and profited from America’s Financial armageddon.

A DETOUR

“The real problem of humanity is the following: we have Paleolithic emotions ; medieval institutions ; and god-like technology

E.O WILSON, sociobiologist and Pulitzer Prize-winning author

As of noon on Friday, global equities were little changed on the week while the yield on the US 10-year Treasury note was sent lower by 14 basis points, to 1.70%, on concerns that the rapidly spreading coronavirus outbreak begun in China could inhibit global growth. The price of a barrel of West Texas Intermediate crude oil declined $4.50 to $54.50. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), rose to 13.5 from 12.3 a week ago. 

MACRO NEWS

China scrambles to contain coronavirus

At least 11 Chinese cities, including the important transportation hub of Wuhan, are on lockdown ahead of Lunar New Year celebrations, which begin today, as officials scramble to contain the spread of a deadly coronavirus. Many public celebrations have been cancelled, and travel is being curtained during one of year’s busiest travel periods. Early estimates suggest the epidemic could shave 0.5% to 1% from China’s projected 2020 growth rate of 6%. As a result, prices for commodities such as oil have fallen this week, as have most interest rates, amid dampened prospects for a global economic rebound following last year’s trade disruptions. Despite isolated case appearing in multiple countries, including the United States, officials from the World Health Organization have so far stopped short of declaring the outbreak a public health emergency of international concern.

Digital tax row temporarily set aside

France and the US have agreed to await further negotiations being led by the Organization for Economic Cooperation and Development (OECD) over the taxation of digital services provided mainly by Silicon Valley technology giants. The OECD plans to unveil a universal cross border system by the end of the year, which could allow governments to tax companies that have no physical operations in their countries. France was set to move ahead with its own digital tax, while the US was preparing to levy retaliatory tariffs before reaching a short-term truce at the World Economic Forum in Davos, Switzerland this week. The United Kingdom is exploring its own version of the tax, a factor that could complicate post-Brexit US-UK free trade talks. While in Davos, US President Donald Trump repeated that he will tariff US imports of European autos and auto parts if the European Union does not reach a trade agreement with the US. Officials from the US expressed hope that a deal can be reached before the end of the year.

ECB launches strategic review

The European Central Bank left monetary policy unchanged on Thursday but announced that it was undertaking a broad strategic review that it hopes to complete by the end of 2020. The review will examine the bank’s formulation of price stability, monetary policy toolkit, economic and monetary analysis and communications practices. It will also assess financial stability, employment and environmental sustainability. As a result of the review, analysts expect the ECB may shift its inflation target slightly higher from the present close to, but below 2%.

Brexit on track for 31 January

Queen Elizabeth II assented to the Brexit withdrawal bill this week, the final leg in journey that began three and a half years ago. European Union leaders and the European parliament are expected to rubber stamp the deal next week. Negotiations will then begin on the future relationship between the UK and the EU, with negotiators from the UK suggesting they will not attempt to closely align with existing EU rules, a potential negative for UK exporters. However, business optimism has risen sharply in the wake of December’s general election, with the Confederation of British Industry reporting the biggest jump in optimism since the measure was created in 1958. 

US flash PMI shows services continue to outpace manufacturing

Activity in the US service sector improved in January, according to data released today by Markit. Its preliminary service sector purchasing managers’ index for January rose to 53.2 from 52.8 in December. The manufacturing PMI declined to 51.7 from 52.4 the prior month. In the eurozone, the situation was reversed as the services PMI declined to 52.2 from 52.8 while the manufacturing PMI rose to 47.8 from 46.3.

Political instability in Italy is once again on the rise, with Luigi Di Maio resigning this week as the leader of the Five Star Movement, a member of the ruling coalition. The party’s prospects have been dimming as it has struggled to transform itself from a group of antiestablishment agitators to a governing party. Its performance in regional elections this weekend will be closely watched.

US Secretary of the Treasury Steven Mnuchin said this week that the Trump administration is working on a second round of tax cuts, aimed at the middle class, while also noting the need for deficit reduction. The secretary expressed support for a stable dollar, in contrast with President Trump, who has often called for a weaker greenback.

North Korea says it is no longer bound by the moratorium on nuclear and missile testing it signed with the US. The government says that the US did not meet North Korea’s deadline for showing flexibility on sanctions.

The impeachment trial of President Trump in the US Senate enters its fourth day, with Democratic House managers expected to conclude their presentation today. The president’s defense will begin on Saturday and is scheduled to last three days.

EARNINGS NEWS

With nearly 17% of the of the constituents of the S&P 500 Index having reported for Q4 2019, blended earnings per share (which combines reported data with estimates for those who have yet to report) shows that earnings growth is running at a 1.9% year-over-year pace while revenues are seen rising 2.7% compared with the same quarter a year ago, according to FactSet Research. Looking ahead, Q1 earnings are projected to rise around 4.5%.

THE WEEK AHEAD

Date	Country/Area	Release/Event
Mon, 27 Jan	United States	New home sales
Tue, 28 Jan	US	Durable goods orders, consumer confidence
Wed, 29 Jan	US	Fed rate-setting meeting
Thu, 30 Jan	eurozone	Economic sentiment indicator, unemployment rate
Thu, 30 Jan	United Kingdom	Bank of England rate-setting meeting
Thu, 30 Jan	US	Q4 gross domestic product
Fri, 31 Jan	Japan	Retail sales, industrial production, unemployment
Fri, 31 Jan	eurozone	GDP, consumer price index
Fri, 31 Jan	US	Personal income and spending

Stay focused and diversified
In any market environment, we strongly believe that investors should stay diversified across a variety of asset classes. By working closely with your financial advisor, you can help ensure that your portfolio is properly diversified and that your financial plan supports your long-term goals, time horizon and tolerance for risk. Diversification does not guarantee a profit or protect against loss.

The information included above as well as individual companies and/or securities mentioned should not be construed as investment advice, a recommendation to buy or sell or an indication of trading intent on behalf of any MFS product.

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The views expressed in this article are those of MFS, and are subject to change at any time. No forecasts can be guaranteed.

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