IRAs have wonderful tax advantages. The traditional IRA offers the possibility of a tax deduction (depending upon one’s income and tax filing status) and full deferral of taxes on investment earnings until withdrawal. The Roth IRA does not give rise to a deduction, but all withdrawals are potentially tax free, including withdrawals of investment earnings. Withdrawals of contributions are always without tax consequence. Finally, the rules for Required Minimum Distributions (RMDs) that kick in at age 72 do
not apply to Roth IRAs.

Traditional IRA

The conventional wisdom has been that traditional IRAs are better if one’s tax bracket will be going lower during retirement and the deduction happens during the working years in the higher brackets. However, the highest tax brackets now apply at income levels much higher than the deduction thresholds, so this analysis has lost much of its force.

Roth IRA

The Roth IRA is to be preferred if one hopes to preserve tax deferral for as long as possible. Also, if one wants to take $10,000 out of a Roth IRA to cover certain retirement expenses, such as a family cruise, only $10,000 need be withdrawn. With a traditional IRA, one must withdraw enough to cover the income taxes as well as the retirement expense. That might mean, for example, that $13,000 would have to be taken so as to cover both the retirement expense and the tax on the withdrawal. However, here are some situations in which the traditional IRA may be the better choice, because lowering your adjusted gross income will affect more than just your tax bill.

You are buying health insurance through a state marketplace. Federal subsidies are available to those who purchase their health insurance from a state marketplace. The subsidies are tied to Modified Adjusted Gross Income (MAGI), and contributions to a traditional IRA will lower one’s MAGI. As income falls, the subsidy grows. For 2020, subsidies are available to those with less than $49,960 of income ($67,640 for married couples).

You plan to apply for an income-based repayment plan for your federal student loans. Some programs link repayments to adjusted gross income. Contributing to a traditional IRA may generate both an income tax deduction and a reduction in loan payments. Some loans may be forgiven in 20 to 25 years, or in the case of some public service situations, as little as ten years. You want to lower the Medicare surcharge. Medicare looks back two years at your income to determine the surcharge on your monthly payments, which can range from $202 to $491 per month. Contributing to a deductible IRA may lower your income enough to reduce that surcharge. If you are working and can contribute to a 401(k) plan, the opportunity for reducing adjusted gross income is even greater. Anyone who is 63 or 64 and planning to enroll in Medicare at age 65 should take a careful look at this option.

You earn too much to contribute to a Roth IRA. If your 2020 MAGI is over $139,000 ($206,000 for marrieds filing jointly) you are not eligible to make a contribution to a Roth IRA. You are still eligible to make a nondeductible contribution to a traditional IRA, and the tax on investment earnings will be deferred for the deductible and nondeductible portions alike. As a high income earner, if your desire is to still contribute to a Roth IRA, you may wish to consider a “backdoor Roth IRA” strategy as a means of indirectly contributing to a Roth IRA. In essence, an IRA owner makes a non-deductible contribution to a Traditional IRA and then later converts it to a Roth IRA. Before using this strategy, however, it is important to discuss the tax implications with your tax advisor. Also, please keep in mind that, as a result of recently enacted legislation, converting assets from a Traditional IRA to a Roth IRA can no longer be reversed.