What Kind of IRA Is Right for You?
Investors should consider the different tax treatments, benefits, and drawbacks associated with the various types of IRAs, says Morningstar's Christine Benz.
Note: This video is part of our “Get It Done” week on Morningstar.com: All week we will feature articles and videos offering guidance on ways to help tackle those nagging items on your financial to-do list.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's "Get It Done Week" here at Morningstar and one thing a lot of investors want to get done is making an IRA contribution. I'm here with Christine Benz, she is our director of personal finance, to demystify the process.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: So, we've passed the deadline for 2015 IRA deadlines, but 2016 is still very much on the table. What's the first step in thinking about contributing to an IRA?
Benz: Well, the first step is to think about what IRA type you're able to contribute to. Morningstar.com has an IRA calculator that lets you plug in your income, whether you can contribute to a company retirement plan, and it will show you how much you can contribute to various IRA types. So that's really the first step. For many people their income and whether they are contributing to a company retirement plan will determine their next steps. So, it will essentially give them their answer on the right IRA type to contribute to.
Glaser: So, what are the major types that could potentially be an option?
Benz: Well, there are two major types--one is Roth; one is what's called a traditional IRA. Under the traditional IRA heading, though, there are two subtypes. So one would be a contribution to a traditional IRA that you'd be able to deduct on your tax return. The other type of traditional IRA contribution would not be deductible.
Glaser: So, what are the big differences there? Is it in the tax treatment?
Benz: It is. So with Roth contributions you are contributing aftertax dollars. The money is compounding on a tax-free basis and then the withdrawals in retirement are also tax-free. With a traditional deductible IRA, it's really just the opposite. So, you are contributing pretax dollars and that you are able to deduct that contribution you're enjoying tax-deferred compounding. But then when you pull the money out in retirement, that money, presuming that it hasn't been taxed in any way, will be subject to your ordinary income-tax rate.
Glaser: So, if you are eligible for either a traditional deductible IRA or a Roth IRA, how do you decide between the two? What are the big swing factors?
Benz: It's a tough question, but the name of the game is really to think about whether you need the tax break more at the time of the contribution or whether you expect to need it more when you're pulling the money out in retirement. So, for folks who are just starting out in their careers, they expect their income to really take off over time and expect that they will be putting a lot into their retirement accounts over time, it may make sense to prioritize the Roth contribution. So, put the aftertax dollars in, take the tax haircut at the outset but then enjoy the tax-free compounding and tax-free withdrawals.
On the other hand, for folks who are maybe a little more advanced in their careers haven't yet amassed a lot in retirement savings, for them it may actually be more advantageous to take advantage of the tax break at the time of contribution. So, make that deductible contribution. They will have to pay taxes when they withdraw the money in retirement, but they'll be paying taxes at a lower rate than when they made the contribution. So, it can be tricky to figure out what is the right course of action. Those two are sort of at the opposite extremes. A lot of people are more in the middle.
Glaser: If you are in the middle, you really are making what's at best an educated guess of what tax rates are going to look like let alone your own income. What would you say to those people? How do you think about that? Do you want some of one, and some of the other, and kind of hedge your bets?
Benz: Yeah, I think that's the right course of action, Jeremy. This idea of tax diversification makes a lot of sense when you're thinking about your financial accounts. The last thing you want to have happen is to get to retirement and have all of your retirement assets be subject to ordinary income tax when you pull them out. So, ideally, as we all go along and are accumulating retirement savings, we're thinking about putting assets into Roth receptacles, which will be able to enjoy those tax-free withdrawals, into traditional tax-deferred receptacles as well as perhaps taxable accounts. So it makes sense to think about diversification while you're in accumulation mode.
Glaser: And when you're in that accumulation mode it is important to actually invest IRAs. When you make those contributions in cash, you do need to make sure you actually make an investment selection, too.
Benz: Absolutely. Some Vanguard data showed that actually many people just rush in that contribution and then let the money sit in cash. They don't make any choice about where it's going. They don't get it invested in the market and there can be an opportunity cost to doing so. Especially, if you have a very long time horizon and if you're doing that year after year, the opportunity cost of missed market returns can be pretty significant.
Glaser: Finally, if you're a higher earner, should you consider traditional nondeductible IRAs? Is there any benefit to that?
Benz: Well, there is. So, the traditional nondeductible IRA is sort of the avenue of last resort for people who have the high-class problem of not being able to contribute to a Roth or to be able to make a traditional deductible IRA contribution. It's not attractive as a maneuver where you're going to leave the money in that traditional nondeductible IRA, but there is this thing called the backdoor Roth IRA and the basic idea is that you are contributing to that traditional nondeductible IRA and then after a period of time has elapsed--and there's some debate about how long, but at least a couple of months I would think--after a period of time has elapsed you then can convert those traditional IRA assets to Roth. So, the beauty is that even if you're someone who has been shut out of a Roth IRA because of the income limits, there are no income limits on the conversions. So, you can do the conversion and get some money over into the Roth column. This has been a really popular maneuver since the income limits were lifted on conversions back in 2010.
Glaser: But there are still some caveats you have to keep in mind regarding this?
Benz: Absolutely. So, the first and foremost is what's called the pro-rata rule, which means that when it comes to determining the taxation of an IRA conversion, the IRS looks at all of your IRAs amalgamated together. So, if you have, say, rollover IRA assets that consist of monies that have never been taxed and those are way larger than your new little IRA that you're hoping to convert to a Roth. Nonetheless, that conversion of your new little IRA may be mostly taxable because most of your IRA assets in aggregate are taxable. So, you need to be very careful. This backdoor Roth IRA thing probably is not advisable for people in that situation unless they can somehow perhaps roll in those rollover IRA assets into an employer plan and thereby get them out of the IRA equation, but in many cases this is not an advisable maneuver.
Another thing to keep your eyes open to is the potential for some legislative risk on the backdoor Roth maneuver. So this is a loophole. I know, Jeremy, you interviewed Michael Kitces, the financial planning expert, about this issue, about whether Congress may close this loophole down the line. It seems like the smart money is kind of converging around the idea that it very well could close this loophole. So, while it's legitimate for now, it may not be something that you'll be able to do for many years to come. Congress could close this loophole down the line.
Glaser: Christine, thanks for the IRA advice today.
Benz: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.