Traditional vs. Roth IRAs - This is the first in a series of articles related to IRAs. This week we'll discuss some basic distinctions between Traditional and Roth IRAs and how each are treated for tax purposes. Traditional and Roth IRAs have their own features and you should speak with your Advisor about which plan may be right for you.
To begin with, a Traditional IRA is treated very much like a 401(k) plan at work. Although there are income limitations, the majority of people can deduct the full amount of contributions on their tax return. Any growth on the account through the years is “tax-deferred”, meaning you do not pay taxes until you take retirement distributions later on. When you are ready to take money out for retirement, it is taxable at the tax-rates then in effect.
The “Traditional” thinking on this type of IRA is to contribute to an IRA and receive a tax break now (while in your earning years and making more money), defer gains, and pay taxes on the total amount later on (when in retirement and earning less money).
A Roth IRA is different. With a Roth, you do not receive a tax-break on the amount you contribute. In other words, you make your contributions with “after-tax” money. The big difference in a Roth IRA is how the growth of your account is treated. Not only is the growth tax-deferred, it is actually tax-preferred. This means that when you take out money from your Roth IRA, it is NOT taxed. With a Roth, the only tax you ever paid was the initial amount contributed. Growth is NOT taxed. The thinking on a Roth IRA is to make after-tax contributions (pay the tax now) and not have to pay tax on any future growth.
To properly compare a Traditional and Roth IRA, you must take into consideration your tax savings from a Traditional IRA contribution and weigh this against the amount you had to pay in taxes for your after-tax Roth IRA contribution. If you were to invest this tax savings from a Traditional IRA in a separate investment AND tax-rates remain the same when you're at retirement age, in theory, there would be NO advantage between a Roth and a Traditional IRA. If you did not invest the tax-savings from your traditional IRA contribution or future tax-rates increase, and/or you have more income in your retirement years, then a Roth IRA would be to your advantage.
Next week we'll discuss some of the major factors you should consider before deciding which IRA might be right for you.
Part 2 Back to top
Traditional vs. Roth IRAs - Last week, we discussed basic differences between Traditional and Roth IRAs, particularly how each are taxed. This week, we will continue our discussion on these IRAs by reviewing some factors you should take into consideration before deciding which IRA might be right for you.
1) Eligibility to deduct Traditional IRA contributions - If you or your spouse are an active participant in an employer-maintained retirement plan AND your modified adjusted gross income is too high, you would NOT be eligible for a Traditional IRA deduction. If this is the case, the Roth IRA would be your obvious choice.
2) Whether you invest your savings from your Traditional IRA - If you plan on doing this and all other factors remain the same (i.e. future tax-rates stay constant) there will be no difference between a Traditional and Roth IRA. If you do not plan on investing the tax savings from your Traditional IRA, then a Roth would most likely be the better choice.
3) If you think you may be in a higher tax bracket when you retire or feel that tax rates might rise in the future, a Roth may be a better choice. Remember in a traditional IRA, your distributions will be taxed at ordinary income rates in effect at the time of your distribution. With a Roth, distributions are not taxed at all.
4) Your age and timeframe until retirement - Generally speaking, the longer the timeframe until retirement, the more sense it may make to contribute to a Roth IRA. This is again due to the uncertainty of future tax-rates. If you feel tax-rates will be higher when you retire, you should seriously consider the Roth. No one knows what future tax-rates will be, especially with an aging population, health care costs that continue to skyrocket, and the uncertainty of Social Security. As I said last week, these factors are putting tremendous strain on our government and could cause future tax-rate increases. If tax-rates do rise, then a Roth will end up being a better choice.
5) Existing retirement plans - If you already have other retirement plans, you may wish to contribute to a Roth to diversify the tax treatment on your future distributions.
6) When you need the income - under a Traditional IRA, you must start taking distributions when you reach 70½. If you want the flexibility of waiting longer, a Roth might be a better choice.
These are just some of the factors you should consider before deciding which IRA to contribute to. Taking a look at your total investment picture and discussing your feelings about where tax rates are headed must be taken into consideration. Next week, we'll take a look at some rules and limitations as they relate to Traditional and Roth IRAs.
Part 3 Back to top
Last week we discussed some factors you should take into consideration before deciding which IRA is right for you (Traditional vs. Roth). This week, we'll go over some rules and limitations as they relate to IRAs.
The following apply to both Traditional and Roth IRAs:
Contribution Limits - For the year 2010, an individual may contribute up to $5,000 into an IRA. If you are 50 years or older, you may contribute an additional $1,000 as a “catch up” provision. (For purposes of the catch up provision, you are considered to be 50 years old if you turned 50 anytime on or before December 31, 2010
Contribution Deadline - Taxpayers have until April 15th of the year following the tax year to make contributions. (i.e. You can make contributions for tax year 2010 all the way up to the filing deadline on your 2010 return, which is 04/15/11).
Spousal IRAs - If only one spouse works, both spouses may contribute to their own IRA as long as the working spouse's income equals or exceeds the combined contribution. This is a good to know, particularly in years where you are able to contribute more for retirement.
The following provisions relate primarily to Traditional IRAs:
10% Penalty - The general rule of thumb is that if you take withdrawals from your Traditional IRA before age 59½, you will be subject to a 10% penalty in addition to paying taxes on your distribution. There are exceptions to this rule including death, disability, certain medical expenses and health insurance premiums, and certain qualified higher education expenses.
There are certain times when one must pay a 10% penalty on a Roth IRA distribution but this is limited mainly to Roth IRA conversions and beneficiaries who inherit Roth IRAs. As a general rule, distributions before age 59 ½ on Roth IRAs are subject only to earnings, not on original contributions.
Required Minimum Distributions (RMD) - People who are age 70½ or older MUST take yearly minimum distributions. This minimum is calculated based on rules by the government but are primarily based on life expectancy. The main purpose of this rule is to avoid people from deferring their gains (and their tax liability to the IRS), for extended periods of time.
Next week, in our final series on IRAs, we'll discuss which types of investments might be appropriate for your individual IRA.
Part 4 Back to top
This is our final series on Roth vs. Traditional IRAs. This week, we'll discuss considerations you should take into account before deciding which investments may be appropriate for your IRA. In the future, we'll talk about other types of IRAs (Rollover, Education IRAs, etc.).
So often, I hear people asking me what kind of a return they can get on a Roth or Traditional IRA. The answer of course, depends on what your IRA is invested in. The fact that your investment is “in an IRA” simply means that it is treated differently for tax purposes. The underlying investments will determine what type of return you receive.
For example, if you invest in a CD and designate that CD as an IRA, your return on your IRA will be that of a CD. If you invest in a growth mutual fund, your return will vary depending on how well that particular mutual fund performs over time.
When investing, it's very important to take the following into consideration:
1) Timeframe - How long do you plan on keeping these funds invested? IRAs are generally longer-term investments as the purpose is for retirement.
2) How much do you already have invested? - For example, if you have not participated in a company-sponsored plan and you have no other significant retirement savings and are relying solely on social security, you may have to contribute more than you'd like. Likewise, if you have significant funds already invested, you may not need to “put away” as much money.
3) What is it invested in? - Even if you have invested relatively large sums of money in the past, you may not be where you need to be due to the type of investments you are currently in. If your investments are underperforming or just keeping up with inflation, you may have to change your existing investments to better suit your retirement goals.
4) Your age - If you are younger and if you are willing to be somewhat aggressive, you most likely will not have to invest as much as someone who is nearing retirement age. It's simple math, if you start investing in your younger years, you have more time until retirement over an older individual. This can make a tremendous difference in how much funds you designate toward retirement.
5) Risk or Volatility Tolerance - Even if you have a longer timeframe until retirement, it would not make sense for you to be in more aggressive investments if you are going to worry and lose sleep over fluctuations in your account performance.
As you can clearly see, there is no “one size fits all” solution. Your personality, knowledge of investments, willingness to take action, and other more objective factors all have to be combined to come up with investments that are right for you.
Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative. Securities offered through IBN Financial Services, Inc., 8035 Oswego Rd., Liverpool, NY 13089. 315-652-4426.
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