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.
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.
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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Can I fund my wife’s Traditional IRA in order to do a backdoor Roth IRA even if she is currently unemployed (she is a super homemaker aka CEO of Mommyhood)?
If your wife has no traditional income from an employer for the year, I think you can contribute on her behalf to a Spousal IRA, which can be either Traditional or Roth… and there should not be a need to do a Backdoor Roth IRA, it would just be a Spousal Roth IRA.
Let me do a little more research and I’ll write a full post about this later.
I got another Roth question for you. I recently read about the Kids Roth IRA. I understand my kid has to have “earned income” in order to qualify but they are 2y9mo and 9mo. Could I setup an online business of sorts and pay them as models for the Web site? I wonder if I’d have to go through all the legal steps of registering as a business and hiring paperwork (W4, I-9 etc). I’d love to give my kids a huge headstart with savings so they can be more aggressive financially when they get older. If I had a safety net, I would have been able to make my money go much further.
The short answer is yes, you can.
However, word of caution is that it needs to be “appropriate”, ie. you can’t pay your kids $5000 a year when there is only 1 picture of them on your website. If I was ever going to pay my kids for “modeling” on my website I would make sure to do the necessary due diligence. This would require looking at the appropriate “going-rate” for modeling in the my location and the age range of my children, adjusted for experience. Appropriate record keeping is the key here. The worst case scenario would be that you put all this money away for them and then they are audited later in life and can not prove this income. That would be a monstrous headache. Obviously, letting your accountant know about this ahead of time is also important, so there are no surprises when it comes to tax time.
However, if you are going to go that far from them, you may opt to do the necessary paperwork to make them employees, and give them access to the company 401k (assuming you have one). Having your children work for you in order to maximize their own Roth 401ks while they are young would be awesome. The dream would be that your children were able to provide enough “work” to maximize a 401k as an employeee of your business, which you can match, as well as contribute to their own Roth IRA. Having that much money set aside for them at a such an early age would be insane.
On a side note, you can still set aside money for a Kid’s Roth IRA just for doing chores, but once again, documentation is key here. You can’t pay your kid $1000 a week just to wash your car or something.
Maybe I’ll add this to my ever-growing list of “things I want to post about” and go into a little more depth.
Thanks for your comment Fred.
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