Deciding whether to open a Roth IRA [individual retirement account] or a Traditional IRA is a major decision, with potentially large financial consequences. Both forms of the IRA are great ways to save for retirement, although each offers different advantages.
The Roth IRA, named after Senator William Roth, who championed it, came onto the market in 1998. Roth wanted to take a different approach to retirement accounts than the traditional IRA. In both traditional and Roth IRAs, your money grows tax free while it’s in the account. However, with a Roth IRA, you pay taxes on the front end by investing after-tax dollars, so the money is tax-free when you withdraw. With a traditional IRA, you pay taxes on the back end – when you withdraw the money.
Another difference between the two is the flexibility to withdraw money early. When you withdraw money from a traditional IRA, whatever money you withdraw will be taxed as ordinary income at whatever income tax rates are in place at the time. In addition to this tax, if you withdraw the money before you turn 59 ½, you will be penalized an additional 10 percent tax penalty, unless your withdrawal qualifies under one of the exceptions listed in the tax code.
With a Roth IRA, you can withdraw any of your contributions without any tax or penalty, any time you want. However, you need to be careful how much you withdraw, or you may get stuck with a penalty. In order to make “qualified distributions” in retirement, you must be at least 59 ½ years old, and at least five years must have passed since you first began contributing to the Roth IRA. If you withdraw before age 59½, you will be penalized with a 10 percent tax penalty, unless it’s for a qualifying reason, such as college expenses for you, your spouse, children or grandchildren; medical expenses greater than 7.5 percent of your adjusted gross income; a first-time home purchase up to $10,000; or the costs of a sudden disability. Money converted into a Roth IRA cannot be taken out penalty-free until at least five years after the conversion.
In Women & Money, financial expert Suze Orman writes: “A Roth IRA also gives you more choice about what you can do with your money in retirement. You are not required to make any withdrawals if you don’t need the money. With Traditional IRAs, you are required to start taking money out once you reach the age of 70 ½. This requirement can make a significant difference in the amount you leave for your heirs. You can leave more money in your Roth IRA because distributions are not required. Any money in your Roth upon death will pass tax-free to whomever you designated as your beneficiary. With a traditional IRA, your heirs will need to pay ordinary income taxes on the money they inherit or withdraw.”
Not everyone qualifies for a Roth IRA and how much can be saved is dependent upon age. If you are under 50, you can contribute $5,500 toward retirement in a Roth IRA. If you are married, each individual can set aside $5,500 toward their retirement, even if only one partner works. The contribution limit is the total limit across any number of Roth accounts rather than per account. If you are 50 or older the same $5,500 contribution limit applies, however, you are also allowed to contribute an additional $1,000 as a “catch up” contribution toward retirement, for a total of a $6,500 contribution.
To qualify for a Roth IRA you need to be:
- Single or head of household: Earnings must be less than $114,000 to fully contribute to a Roth IRA.
- Married filing jointly or a qualified widow(er): Earnings must be less than $181,000 to fully contribute to a Roth IRA.
- Married filing separately: Earnings must be less than $10,000 to fully contribute to a Roth IRA (Note: Married, filing separately can use the limits for single people if they have not lived with their spouse in the past year).
If you don’t qualify for a Roth IRA, you should look at investing in your own retirement fund outside of a company plan (401k). A traditional IRA is a tax-deferred retirement savings account. You pay taxes on your money only when you make withdrawals in retirement. Deferring taxes means all of your dividends, interest payments and capital gains can compound each year without being hindered by taxes – allowing an IRA to grow much faster than a taxable account.
Traditional IRAs come in two varieties: deductible and non-deductible. Whether you qualify for a full or partial tax deduction depends mostly on your income and whether you have access to a work-related retirement account like a 401(k).
A deductible IRA can lower your tax bill by allowing you to deduct your contributions on your tax return – you essentially get a refund on the taxes you paid earlier in the year. You fund a non-deductible IRA with after-tax dollars. You cannot deduct contributions on your tax return. Whether you qualify for a deductible IRA depends on your income, filing status, whether you have access to an employee-sponsored retirement plan at work, or whether you receive Social Security benefits.
Like the Roth, in 2014 the maximum contributions limit is $5,500. If you are age 50 ½ or older you can add another $1,000 for a maximum contribution of $6,500.
Unlike a Roth IRA, with a traditional IRA, you must take required minimum distributions after age 70 ½. The amount of the distribution depends on how much you have saved in the account and on your life expectancy, according to tables published by the IRS. One of the benefits of contributing to an IRA is the potential to decrease your taxable income.
If you withdraw money from a traditional IRA before you turn 59 ½, you must pay a 10 percent tax penalty, in addition to paying regular income tax. Like the Roth IRA, the same qualifying reasons for withdrawal can apply. For some individuals, IRA contributions are fully or partially income tax deductible. Typically, those who qualify do not have a 401(k) or retirement savings plan through work. You must also meet certain income limitations. The income levels are up slightly from last year. In 2014, your deduction amount phases out if your income is between $60,000 and $70,000. If you are married and file jointly you could likely take a deduction if your income is less than $96,000, and you will be ineligible if your income exceeds $116,000. If your spouse is covered at work, but you are not, the phase out income amounts range from $181,000 and $191,000.
Individuals under age 70 ½ with earned income are eligible to make IRA contributions. With a traditional IRA, you may be able to deduct your contributions on your taxes, which can help lower your tax bill. Your eligibility to deduct is based on your modified adjusted gross income (MAGI) and whether you participate in a retirement plan at work.
Which IRA is right for you? Start by looking at your income. There are income limits for Roth IRAs, so if your income is above those limits, a traditional IRA is the only one for you. If you are eligible for both a Roth and a traditional IRA, then you’ve got to run some numbers.
In general, a traditional deductible IRA is appropriate if you expect to be in a lower income tax bracket when you retire. By deducting your contributions now, you lower your current tax bill. When you retire and start withdrawing money, you’ll be in a lower tax bracket, giving less money overall to the tax man. If you expect to be in the same or higher tax bracket when you retire, you may instead want to consider contributing to a Roth IRA, which allows you to pay your taxes now.
It can be difficult, if not impossible, to guess which tax bracket you will be in later in life. Consider diversifying. For example, if you already have a tax-deferred 401(k) plan through your employer, you might want to invest in a Roth IRA, if you are eligible.
As in most, if not all, financial matters, it is best to speak with an independent financial advisor who can help guide you in the right direction.
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