2/25/2014 8:30 PM ET|
Traditional or Roth IRA: Which should you choose?
IRAs let you save on taxes while you save for retirement. But with two types, which one is right depends on ... well, you.
Congress doesn't do much right, it seems. But when it created individual retirement accounts (IRAs) in 1974, it gave Americans one of the most versatile investment vehicles ever conceived, and one that has become the fundamental building block for millions of retirement plans.
And when Congress created the Roth IRA in 1997, they took a great idea and made it even better.
With a traditional IRA, you receive a tax break in the tax year in which you make a contribution, and you pay no taxes on the dividends, interest and capital gains that accumulate. You only pay taxes once you start to take distributions -- in retirement. With a Roth IRA, you get no tax break in the year of the contribution, but you are able to remove the funds tax-free in retirement.
In 2014, you can contribute $5,500 to either type of IRA and $6,500 if you are over the age of 50.
Let me be clear: If you have income from a job or from a small business, you should have an IRA or a Roth IRA -- or perhaps both, depending on your situation. There are no exceptions to that statement. None. So if you don't already own an IRA or Roth IRA, opening at least one should be at the top of your to-do list in 2014.
- InvestorPlace: Everything You Need to Know About IRAs
Should I open a traditional IRA or a Roth IRA?
The answer to this question is going to depend primarily on three factors:
- Your age
- Your income
- Whether you have access to a 401k plan or comparable retirement plan at work
When you fund a traditional IRA, Uncle Sam is giving you a tax break. But he still wants his money. Hence, we have "minimum required distributions." When you reach the age of 70½, you are required to start withdrawing from your IRA account and to pay ordinary income taxes on the withdrawals.
These days, a lot of Americans continue to work well into their 70s, whether they need the money or not. Having a job, even if it is part-time, gives a sense of purpose (and frankly, something to do). If you are approaching or already over the age of 70, it makes sense to contribute to a Roth IRA, which has no distribution requirements, because you are not permitted to contribute to a traditional IRA after the age of 70½, and even if you could, it wouldn't make sense as you would have to start withdrawing it immediately thereafter.
Your ability to contribute to a Roth IRA gets phased out at higher incomes -- and unfortunately, the income levels aren't as high as you might think. You can contribute the full $5,500 to a Roth IRA if you are a single taxpayer with a modified adjusted gross income (MAGI) less than $114,000. Contribution amounts start to phase out at MAGIs between $114,000 and $129,000, and if you make $129,000 or more, you cannot contribute at all.
Married couples can make a full contribution to a Roth IRA if their combined incomes are less than $181,000. Contribution limits for a Roth IRA phase out between $181,000 and $191,000, and at incomes of $191,000 or more, you cannot contribute at all.
So, if you are considered a high-income taxpayer, the Roth IRA is not an option for you.
Let's assume that your income makes you eligible for either a traditional or Roth IRA. There are still other income factors to consider.
Let's say that you are married with two children and, due to the responsibilities of raising children, your spouse does not work. Let's also assume you have a mortgage. If this describes you, chances are good that your dependent and home deductions put you in a very low tax bracket. In this case, the current-year tax deduction for a traditional IRA isn't going to be worth much, and you're going to be much better off with a Roth IRA.
But 10 to 15 years from now, your kids will have left the nest and your spouse has returned to work. You're also paying less in mortgage interest because you've paid down a large chunk of your mortgage. You're going to be in a much higher effective tax bracket. Taking an immediate deduction with a traditional IRA suddenly looks a lot better.
The questions you have to ask yourself are "What tax bracket am I in today?" and "What tax bracket do I expect to be in later?"
If your situation changes, no big deal. This is not monogamous marriage. You're allowed to open multiple IRAs and to contribute to whichever one makes the most sense in a given tax year. Just make sure that you keep the total contribution under the $5,500 limit.
Retirement accounts at work
If you have access to a 401k or comparable retirement plan at work, your ability to deduct a traditional IRA contribution on your tax return may also be phased out. This doesn't mean that you can't contribute, mind you. It simply means you can't deduct the contribution. In this case, the Roth IRA clearly is going to be a better option for you.
But if you are unable to contribute to a Roth IRA due to, say, high income restrictions, the nondeductible traditional IRA is still a viable option. You just need to keep track of your basis so that you are taxed only on your earnings. (This is something you'd probably want to discuss with your accountant).
When would a nondeductible traditional IRA be appropriate? If you are aggressively saving for retirement, and you have already maxed out your company 401k plan, then tossing an additional $5,500 into an IRA can be a nice bonus.
Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities.
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Not mentioned was the employer match. To me, even if a Roth was a much better fit for my plans and situation, I would, and encourage others as well, never pass up free money. Even if the plan stinks, there has to be something to take advantage of it.
The article is correct about the income limits on MAGI and the necessity of having earned income to qualify for a Roth. However, it is possible for ANYONE who has an IRA, even with very high MAGI to roll over that existing or new (or a portion of) IRA into a Roth if they are willing to pay the taxes on the entire amount that is being rolled over. That is what I did. Contributions to new IRA can be made every year and rolled over into Roths as many times as one wishes... UNTIL they change the law. I would open or roll over into a Roth as soon as possible. As the author stated, it's just too good a deal to pass up.
As to the age or other considerations when contemplating starting or converting to a Roth, I did mine when I was in my early 60s because I firmly believe that practically NO ONE will ever be in a lower tax bracket than they are in at the present moment. We will all pay ever higher taxes to pay for what the government has spent and is continuing to spend.
Enjoy this while you can!
If one spouse is working and the other is not - but has investment income, and both are over 55, what are the contribution limits? Can both contribute the max of $6500 for a combined total of $13K? And does a Roth conversion count towards the limits?
There may not need to be a fight.
Just persuade Americans into installing a National Sales Tax, or Consumption Tax instead of an Income Tax and you've done it. When you go spend the "non-taxable" Roth funds, you've just taxed it........again.
Won't happen? Just remember Herman Cain's 9/9/9 much-loved plan and the score of Republicans pushing the idea of a "simple" solution, by putting in a 17%- 20% National Sales tax. The rich go from a top 39.6% rate, to a 17%-20% rate. The middle-class goes from a average of 10% current effective tax rate to 17%-20%. No wonder the Republicans love the idea.
The first rule of tax-planning; Take the deduction now while it's still in place.
I don't know why stooges on her think Republicans give a damn about anyone but the rich.
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