Dividend Growth RetirementI’ve decided to make some changes in how I save for retirement.  Currently, as far as retirement savings go, I invest purely in a 401k account through my employer.

I also have a taxable brokerage account for stocks and another for a high yield mutual fund that I invest in.  However, as far as using a tax advantaged account goes, up to this point I have only been utilizing the 401k.

Recently, I’ve been giving retirement planning a lot more thought as I worked through my new book Retire With Dividend Growth.

While I think the 401k plan through my employer offers many decent investment options, it doesn’t allow for me to follow the main investment strategy I believe to be the best.  I am a dividend growth investor.  My 401k currently only allows me to choose from a variety of mutual funds as my investment options.

For this reason, I’ve been giving some thought to opening either a Roth IRA or a Traditional IRA account through an online brokerage.  My plan will be to continue investing in my 401k in order to receive the full company match.  However, once I’ve invested enough to receive the full match I will then funnel additional retirement savings into the IRA account.  The IRA account will give me the benefit of tax advantage savings while also giving me the opportunity to follow the dividend growth investment strategy.

As I’m considering changing up my retirement savings, I have begun researching the differences between a Roth IRA and a Traditional IRA in order to make my decision about which type of IRA account to open.

Let’s review the differences between the two types of Individual Retirement Accounts.

Traditional IRA

Investors can contribute up to $5,500 a year to a traditional IRA.  If you are over the age of 50, you are allowed to contribute an additional $1,000.

The contributions to a traditional IRA may be tax deductible in the year you make the contributions.  There are income limits that determine whether the contributions are currently tax deductible or not.

At the present time, if you file your taxes as a Single filer then you can contribute as long as your income is below $59,000 per year.  If you make $69,000 a year, you can still contribute to a traditional IRA but your contribution deduction will be limited or phased out to a certain point.  If you are single and making over $69,000 a year then you cannot deduct traditional IRA contributions.

If you are married filing jointly, you can contribute and fully deduct from your taxes the contribution as long as your household income is below $95,000.  The amount of your contribution that can be deducted is phased out between household income of $95,000 up to $115,000.  If you make above $115,000 then you will not be able to contribute to a traditional IRA.

For the traditional IRA, your contributions will be tax deductible in the current year.  During your retirement years, your withdrawals from a traditional IRA will generally be taxed as ordinary income at your income tax bracket in the year the withdrawals are made.

If you make early withdrawals from a traditional IRA (before age 59 1/2) then you will have to pay a 10% penalty on those withdrawals except for certain situations.

At age 70 1/2, you will be forced to begin taking required minimum distributions from a traditional IRA.

So to sum up a traditional IRA:

  • Contributions are tax deductible in current year.
  • All withdrawals during retirement are taxable as ordinary income.
  • The earnings and capital gains grow tax deferred but will be taxed as ordinary income during withdrawal.
  • There is an early withdrawal penalty.
  • You are required to begin withdrawals (and pay taxes) at the age of 70 1/2 even if you don’t necessarily need the money yet.

Roth IRA

Investors can contribute the same amount per year to a Roth IRA as a traditional IRA.  That amount is $5,500 and an additional $1,000 if you are over 50.

Your contributions to a Roth IRA are not tax deductible in the year you make them.  In other words, you pay taxes on the money you contribute to a Roth IRA in the year it is earned.

In order to be able to contribute to a Roth IRA, single tax filers must earn less than $112,000 in a year.  Married filing joint couples must earn less than $178,000 in a year.  As you can see, the income limits for eligibility to contribute to a Roth IRA are considerably higher than for a traditional IRA making this a good choice for higher income earners.

The big benefit of a Roth IRA is that when you make your withdrawals during retirement (after age 59 1/2), the withdrawals will be tax free.  All of the dividends, interest income and capital gains can be withdrawn without owing any taxes on them as long as the account has been open for at least 5 years.

You can withdraw your contributions to a Roth IRA (but not your earnings) penalty free anytime after the account has been open for 5 years.  This is a big benefit over the traditional IRA which penalizes early withdrawals with just a few exceptions.

Another big benefit with the Roth IRA is that there is never a required minimum distribution.  If you are fortunate enough to have enough income during retirement from other sources, you won’t be required to withdrawal from your Roth IRA.  You can leave your investments in the account to continue to grow tax deferred until you either need it or pass away and leave to your beneficiaries.

So to sum up a Roth IRA:

  • Contributions are not tax deductible in current year.
  • All withdrawals during retirement are tax free as long as the account has been open at least 5 years.
  • The earnings and capital gains grow tax free and will not be taxed upon withdrawal.
  • You are allowed to withdrawal contributions (but not earnings) penalty free as long as the account has been open at least 5 years.
  • You will never be required to make withdrawals from the account if you choose not to.

Choosing Between a Roth IRA and Traditional IRA

Really, both accounts have their different advantages and disadvantages depending on the individual investor.

Depending on individual circumstances, one account may be a better choice over the other.

In general, if you believe your tax rates are lower now than they will be during retirement then it may be a good choice to go with the Roth IRA.

If you believe your tax rates are higher now than they will be during retirement then it may be a good choice to go with a traditional IRA.

My Choice

For me personally, I believe the Roth IRA makes the most sense at my current time.  There are a few different reasons I come to this conclusion.

First is the income limit.  As a married filing joint taxpayer, soon I will be phased out of being able to contribute to a traditional IRA.  The higher income limits of the Roth IRA makes the Roth a better choice for my family.

Also, personally I have the belief that my tax rates will be higher in the future.  Do to my investment activities and career trajectory, I believe I will be earning a much larger income later in life than I currently am.  At the same time, I also believe that federal income tax rates will be increased sometime in the future.  The combination of both will leave me with a higher tax bracket during retirement.

Another reason I prefer the Roth IRA is that if needed, I can withdraw my contributions (not the earnings) penalty free.  I always like to have my cash and investments as liquid (easily available to me) as possible in case I need it in the future.  While I am prepared with an emergency fund savings account as well as some investments in a taxable brokerage account, the ability to withdraw contributions from a Roth IRA gives me that little extra peace of mind.

Last, I like the idea that I will never be required to make a withdrawal if I don’t need the money.  I am very fortunate enough to have an employer sponsored pension (defined benefit plan) as well as my 401k savings plan through my employer.  I also save and invest frequently in a taxable brokerage account.  It may be possible that I never need the money saved in my Roth IRA.  I like that I won’t be required to withdrawal that money and can instead allow it to continue to grow tax deferred for my heirs.

Soon, I plan on opening my Roth IRA through my online brokerage and getting started with my dividend growth retirement savings.

What about you?  Do you invest in a Roth or traditional IRA?  If so, why did you choose the type of IRA that you currently use?

Be sure to check out my book discussing using the dividend growth strategy for retirement.  You can purchase the book Retire With Dividend Growth here on Amazon.

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12 Responses to Roth IRA vs. Traditional IRA

  1. Extremely informative article! I’ll be contributing to my ROTH IRA, but since my husband does not have a 401K plan at work, I will be setting up a Traditional IRA this year for him through Vanguard.

    • Dan Mac says:

      That sounds like a good idea Savvy. One thing I don’t discuss in this article (possible future article idea) is the strategy of tax diversification. During retirement, if you have both a tax deferred account (401k, traditional IRA) and an account that won’t be taxed at withdrawal (Roth IRA or Roth 401k) then it is possible to manage your withdrawals from both accounts to try to stay in a lower income tax bracket during retirement. So sometimes having both a Roth and traditional can be a good idea as well.

      • I am trying to max out 401K, Roth and SEP IRA for a second year in a row. I actually expect that I will be in a lower tax bracket when I retire, which is why 401K deductions and IRA deduction are perfect for me to take today. Once my taxable income goes down, I would be able to slowly convert that 401K and IRA into ROTH slowly.

        Therefore I will receive tax deductions today, and not pay a ton on taxes in the future.

        • Dan Mac says:

          Sounds like you have a good plan Dividend Growth Investor. I think the important thing is for everyone to think about their own individual situation which will infer which type of account may be best to open. Sounds like you’ve thought your plan out and just need to execute. Good luck!

  2. Joe S. says:

    Dan, The ROTH IRA is the best choice for a DGI investor in my opinion. My Roth is made up of mostly dividend growth stocks and I plan to let those dividends re-invest until I begin to collect when needed….and this is the key “when needed” and the Roth makes that best sense to me. Imagine having a portfolio that pays you with “raises” tax-free..I set up my ROTH once it was introduced years ago and have never looked back.

    Regards,

    Joe

    • Dan Mac says:

      Thanks for your opinion Joe. I agree the Roth IRA is a good choice for dividend growth investors. I like the flexibility offered also in that you can withdraw penalty free your contributions if you ever need them but also if you never need to make withdrawals, you won’t be forced to.

  3. dax says:

    great article, but what you forgot to include is that you can contribute to a spouses IRA using the following rules:

    During the 2013 tax year, the spouse without earned income:

    -Fully deductible if MAGI is less than $178,000 (joint)
    -Partially deductible if MAGI is between $178,000 and $188,000 (joint)
    -No deduction if MAGI is over $188,000

    • Dan Mac says:

      Thanks for that info dax. I’ve actually not been in that situation but it is good info for those with spouses who do not have an earned income. Definately good to take advantage and be able to contribute to an IRA for both spouses.

  4. Rusty says:

    Liked your article on Roth vs. 401K. In planning to retire soon, I’m going to work up a long term spreadsheet and see if keeping funds in a Roth with a 4-5% return will yield more income in later years vs. a taxable 401-K considering a projected tax rate and annual income. Can you expand on this idea in your course? You did get me thinking! Thanks; going to buy your book!

    • Dan Mac says:

      Thanks Rusty, that sounds like an interesting idea and one I’ll have to work out the math on to see if it would make much of a difference. I definitely want to go into more detail in a later article, possibly Mondays, discussing strategies involved using both a Roth and a traditional 401k to lower your tax burden during retirement. I’ll test a couple different scenarios and see how they play out.
      Thanks for reading!
      -Dan Mac

  5. Great post Dan. I gave up contributing more to my 401k than my company would match a few years back and have never regretted it.

    • Dan Mac says:

      Thanks Zach, I think it is the way to go. Instead, contribute that money to an IRA and you’ll have much more freedom in investment choices. For me, this means being able to invest in dividend growth stocks.

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