Two types of IRAs exist — the Traditional IRA and the Roth IRA. While both share a significant number of features, there are also major differences between the two.
It’s these similarities and shared characteristics that often confuse many consumers.
Traditional IRA Basics
According to IRS regulations, money within an IRA must remain untouched until the account owner reaches the age of 59-1/2. Withdrawals from an IRA will create an income tax liability, as the amount withdrawn is considered current earnings and will be taxed at the owner’s then-marginal tax rate.
So, it is important to realize that IRA withdrawals can actually have a rather significant impact, particularly if your income is on the cusp of breaking through to the next tax bracket.
Another potentially important facet of the Traditional IRA is its upper age limit. Since the money within the IRA has yet to be taxed, the IRS will force you to begin taking distributions once you reach age 70-1/2.
This is because the IRS isn’t willing to wait forever for the taxes due on the money within your account. So, a somewhat complex calculation is performed annually beginning with the year in which you reach age 70-1/2, and the result of that computation is your Required Minimum Distribution, or RMD.
The RMD is an exact dollar amount that you must withdraw from your IRA during that year. The figure is based on your age and the total value of your account. Your age is taken into consideration because the average lifespan is viewed as the target date by which your account should be completely emptied and all tax liabilities satisfied.
Roth IRA Basics
The two major differences with a Roth IRA are: (1) no current-year income tax deduction is given for contributions, and (2) qualified withdrawals (those made after age 59-1/2) are received completely tax-free.
So, in exchange for earmarking some of this year’s income for use during retirement, while still paying income taxes on those contributions, Uncle Sam has agreed to give you a pass on the growth and interest that might accumulate in a Roth IRA. There is no maximum amount of tax-free growth and Roth IRAs do not have RMDs, either.
One thing to keep in mind is that a distribution from a Roth IRA taken prior to age 59-1/2 will not result in any additional taxes or penalties on the portion of the withdrawal that’s considered a return of earlier contributions. However, full income taxes will be due and the 10% early withdrawal penalty will be assessed on the withdrawn growth.
Additionally, to withdraw money without paying penalties and taxes, initial contributions to a Roth IRA must have taken place at least five years prior to the withdrawal.
IRA withdrawals use the first-in-last-out, or FILO, structure, which means partial distributions are considered to come from the account’s growth first. Only after the growth has been withdrawn will distributions be considered a return of contributions.
Typically, the Roth IRA is extremely attractive for investors who are younger and plan on working for at least the next two or three decades. Paying the income taxes on Roth IRA contributions now, while salaries and tax brackets are most likely less than what they’ll be 20 or even 30 years down the road, makes a lot more sense compared to taking a relatively insignificant deduction now and paying, potentially, much higher taxes during retirement.
Roth IRAs versus Traditional IRAs: Which is Better for Dividend Stocks?
A Traditional IRA might not be the best idea for dividend stocks if you expect your tax rate at retirement to be higher than it is today. Sure, you’ll avoid paying taxes on those dividends for years, potentially decades, while they remain shielded in your IRA, but when you finally begin making withdrawals you’ll be paying ordinary income tax rates.
This means that if tax brackets are exactly the same when you retire as they are right now, your tax bracket could potentially be as high as 37%. Of course, that’s today’s highest income tax bracket, but there’s no way of predicting what those brackets will look like in 10, 15, or 20+ years. RMDs can further complicate tax planning when they kick in, and who knows what the treatment (and availability) of Social Security benefits will be like in the distant future.
The tables below show the tax rate differences between qualified dividends held in taxable, non-IRA brokerage accounts, which are taxed at the long-term capital gains rate between 0% and 20%, and ordinary income, which is how Traditional IRA withdrawals are taxed when the time comes.
Following the passage of tax reform in late 2017, here are the cutoffs for taxes on long-term capital gains. These are the rates you pay for qualified dividends held in taxable accounts based on your income level:
As you can see, these rates compare very favorably to ordinary income rates which are assessed to Traditional IRA withdrawals:
However, maintaining a blend of Traditional IRA, Roth IRA, and taxable accounts can help maximize after-tax income in retirement. No one knows what tax rates will be over the coming decades, so having the option to simultaneously withdraw income from various accounts with different tax treatments can provide nice flexibility.
That being said, choosing stable, dependable dividend stocks with a solid history of steady dividend growth is essential to maximizing the long-term profit potential of any account.