When it comes to planning and saving for your retirement, one of the first decisions you need to make is choosing which type of retirement account to open. There are numerous types of retirement accounts, each with their own unique advantages and disadvantages. Though it is beneficial to have so many options, it is important to learn about each of them to know which suits you best. However, it can get complicated, especially knowing that one day your children or grandchildren will inherit what you leave behind. This is where understanding the different tax rules in each account becomes significantly important. A good place to begin is looking at the two most popular retirement accounts: Traditional Vs Roth IRA.
What is a Traditional and Roth IRA?
A traditional and Roth IRA are both individual retirement accounts, with tax advantages. However, they differ in many ways and have their own types of advantages. This leaves it up to you to choose based on your preference. Below is a list of their main advantages and disadvantages to consider
Traditional - The way a traditional IRA is set up is money that is invested in this account is tax-deducted. Meaning, the portion of your income that you contribute to this account, will not be taxed in your yearly income which gives you an immediate tax break. Thus, only withdrawals made from the account in the future will be taxed as income.
Roth - The way a Roth IRA is set up is money invested into the account are after-tax contributions. Meaning, money put into the account has already been taxed and can grow tax free. Thus, withdrawals made in the future will NOT be taxed. However, this will not give you immediate tax breaks on your current income.
Traditional - With a traditional IRA you can contribute pre or post tax dollars. For 2022, the limit is $6,000, and for those 50 years and older, $7,000. In addition, there are no income limitations, anyone with earned income can contribute.
Roth - With a Roth IRA, there are some rules for contribution. Contribution limits are $6,000, and for those older than 50 years and older, $7,000. However, there are limitations based on your Modified Adjusted Gross Income, which in 2022 has changed to $129,000.
Traditional - When it comes to the time of withdrawing money from your Traditional IRA, there are some restrictions. For one, all withdrawals you make after the age of 59 ½ are taxed as income. Additionally, you cannot keep your money in this account forever, by the age of 72 you are required to start making withdrawals.
Roth - When it comes to the time to withdraw money from your Roth IRA, that is when you see its advantages. For one, you will not have to pay tax on any withdrawals since contributions were already taxed before. Secondly, you can keep money in this account for as long as you want. However, if you do choose to withdraw, you can do it penalty and tax free after 5 years of opening the account and age 59 ½.
How These Differences Impacts Inheritance:
When deciding which account you want to pass on for your future family to inherit, most of the decision comes down to taxes and which would give the most benefit.
Roth - According to many financial advisors, a Roth IRA might be the most advantageous account to pass down for inheritances. This is mainly because all money in the account can be withdrawn with no additional fees or taxes. However, it is also important to consider your current tax rate versus your children's potential future tax bracket. If you believe they will have an equal or higher tax, then it would be most beneficial to set up a Roth IRA.
Traditional - Though there are some cons when inheriting a Traditional IRA such as having to pay taxes on withdrawals, there are some pros as well. For example, if at the time you are making contributions you have a high income and net-worth, you may be better off setting up a Traditional IRA since you may have a high tax rate. Therefore, when your children make withdrawals in the future they can liquidate and pay taxes at their own rate. This would essentially help you lose less money.
Reasonably, it could be difficult to predict the future as well as the tax bracket your children will be in. Therefore, it's important to remember if you choose to receive immediate tax advantages with a Traditional IRA, you can always convert it in the future to a Roth IRA. To help choose which retirement account is right for you and include it in your estate plan, contact the Law Office of Inna Fershteyn at (718) 333-2394.