Hi guys, it’s Finance Fridays again and I’m here to talk about Traditional IRA versus Roth IRA today.

I covered this before a little bit in Talking the Talk. I’d recommend you read at least that post first before you read today’s post as a primer. If these topics interest you, then I’d advise you to look at my Finance Fridays Roadmap post next to direct you where to read some more stuff. I should probably update that post since it was last updated in October, but I’ll do that another week.

Stock Photo from: Pexels

What is a Traditional IRA?

So a Traditional Individual Retirement Account (IRA) is an investment account for the purposes of retirement, held by a “custodian” ie. Vanguard, Schwab, Fidelity, etc. You can then invest the money in that account into whatever funds they allow you to use. This is technically a pre-tax account because you can deduct some or most of your contribution.

Sounds like similar to a 401k/403b or 457… is it the same?

Well, it is similar in that it does have some tax-advantages. However, these advantages are not as good as a 401k/403b or 457. 401k/403b and 457s are pre-tax accounts, with maximums of $18,000. As I stated before, if you have access to both a 401k/403b and 457, you can put away $36,000 a year (and should).

A Traditional IRA allows you to put away $5500 a year (or $6500 if older than 50). The main advantage of a Traditional IRA is that you can deduct a portion of your contribution from taxes. Unfortunately, this deduction has a pretty strict requirement. IRS Source

For many of you, you will already have a retirement plan at work, and therefore you will fall into this category. 2016 IRA Deductions and 2017 IRA Deductions

The TL;DR of those charts is that for 2016, if you more than $71,000 as single of head of the household, you can’t deduct anything. If you are married failing jointly, and make more than $118,000, then also can’t deduct anything. Finally, if you are married filing separately and make more than $10,000, you can’t deduct anything.

*for 2017, these values are $72,000, $119,000 and $10,000 respectively.

For this reason, just about all physicians won’t be eligible to deduct any of their contributions from their taxes… which one of its major advantages.

It seems like the tax benefits of a Traditional IRA are lost for doctors, should I still use it?

Well, the benefits aren’t great. However, a Traditional IRA still has a few other tax advantages:

Interest, dividends, and capital gains, are not subject to tax while still in the account. However, upon withdrawal from the account, withdrawals are subject to federal income tax.

So, for simplicity, it serves as an account that grows tax-free. This alone is not that great though… as you will see the better option below.

Also, for completeness, you can convert a Traditional IRA into a Roth IRA, but can not convert a Roth IRA into a Traditional IRA. This is important later, when I will talk about Backdoor Roth IRAs (next week).

So what is a Roth IRA then?

A Roth IRA is a post-tax account, but unlike the Traditional IRA, it has more strict requirements: Roth IRA 2016 and Roth IRA 2017

For simplicity, if you are single, you need to make less than $132,000, and if married filing jointly, less than $194,000, and if married filing separately, less than $10,000.

Like the Traditional IRA tax deduction above, most doctors won’t be able to contribute to a Roth IRA because of the income maximums.

Why are the Roth IRA restrictions more difficult?

Well, it offers some tax-advantages. Although it is a post-tax account, it grows tax-free and also can be withdrawn tax-free.

So, which is better for me?

Well, since you lose the ability to deduct your contributions from the Traditional IRA and will need to pay taxes on it when you withdraw the money later, the Roth IRA is a better option. However, because of the income contribution limits, you aren’t able to use a Roth IRA.

Well, that kind of sucks.

Agreed. However, there is a “Backdoor Roth IRA” which allows you to bypass the strict income contribution limits.

The TL;DR of that is you contribute to a traditional IRA with an asset that generates little or no interest (like Money Market or something), then convert it into a Roth IRA after a day or a few days.

I’ll go over the exact method in my next post, because it can be confusing, especially if you have other retirement accounts.

Sounds good to me, but is this really necessary?

The mainstay of retirement is still going to be maxing your 401k/403b and 457, hopefully with some sort of employer match. Or, if available to you, in a partnership scenario, where your employer will match your $18,000 up to $53,000.

There is no reason to even think about doing a Backdoor Roth IRA unless you’ve already maximized the above. However, for those who want to put away more money outside of those options, then the Backdoor Roth IRA is the next best option, and is slightly better than a Traditional IRA because of the slight tax advantages.

Of course, the Traditional IRA and Roth IRA are both better than a normal brokerage (aka taxable) account. The money you earn is subject to capital gains (ie, it doesn’t grow tax-free).

I apologize if this post was kind of long-winded and boring. However, I felt it was important to understand why people use Traditional IRAs, Roth IRAs, and Backdoor Roth IRAs.

I tried to explain this to a colleague of mine the other day and it came out all jumbled. I thought I knew what I was talking about, but decided to the defer the discussion until I did more research to confirm. I’m glad I did because now I can be more confident when I discuss it with him later.

TL;DR

Traditional IRA is technically a pre-tax account because it allows for tax deductible contributions.

However, most doctors will not qualify for the tax deductible contribution.

For this reason, a Roth IRA is the better option… but we don’t qualify for that either.

To get around this, there is a Backdoor Roth IRA, where you contribute to a traditional IRA then convert it into a Roth IRA. I will go over this in more detail next week.

All that said, the priority should still be in maximizing your 401k/403b and 457 with an employer match. If available to you in a partnership, your group can match your $18,000 contribution to $53,000.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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