Roth vs Traditional IRAs
What is a Traditional IRA
Traditional IRAs are tax-deductible, tax-deferred retirement accounts. This means that the money contributed consists of pre-tax dollars that grow untaxed until distributions begin. For example, a person who earns $75,000 and contributes $5,000 to an IRA would pay taxes on $70,000, less all other available deductions. The taxes on the earnings in the account are also deferred. If, as part of an IRA, the account owner holds stock that does not pay a dividend but appreciates from $15 per share to $18 per share in one year, he or she will not owe taxes on the $3 increase. If the stock pays a dividend and appreciates $3 in one year, taxes are not owed on the increase or the dividends that are paid per share.
Over time, the value of a traditional IRA can increase substantially faster than a regular savings or brokerage account because taxes are not taken out. This allows earnings and additional contributions to compound in larger amounts. Even though the capital gains tax rate is lower than most marginal tax rates, earnings left to compound over long periods of time will grow significantly larger.
Earnings and contributions of traditional IRAs are taxed when the account owner begins taking distributions. He or she can begin taking distributions at age 59 ½ and must begin taking them by April 1 of the year after turning 70 ½. Distributions are taxed at normal income rates. The amounts of the distributions are based on the total value of all traditional IRA accounts and the account owner's life expectancy.
What is a Roth IRA
Unlike a traditional IRA, contributions made to a Roth IRA are not tax deductible. A person who earns $75,000 and contributes $5,000 to a Roth IRA will owe taxes on $75,000, less other deductions. But, like a traditional IRA, earnings that accrue within the account are not taxed.
The big differences between a traditional IRA and a Roth IRA are that distributions are not taxed once they begin after age 59 ½ and distributions at age 70 ½ are not mandatory. This means that the Roth IRA provides tax-exempt retirement savings rather than tax-deferred retirement savings. It also means that the account owner may never have to take distributions from the account.
The Roth IRA is available for single taxpayers whose modified adjusted gross income is $122,000 or less, and married taxpayers who file jointly whose modified adjusted gross income is $179,000 or less.
How to Choose Between a Traditional and Roth IRA
The most common IRA question concerns the decision between funding a traditional or Roth IRA. Is it better to invest pre-tax money today and pay Uncle Sam after the account grows, or is it better to bite the bullet, pay Uncle Sam first, but keep all the earning tax-free? In a nutshell, that's the difference choosing a traditional IRA over Roth.
While it's always best to speak with a qualified tax professional prior to funding either type of IRA, as a rule of thumb, the most important factor in choosing between a traditional and Roth IRA is your current and future income tax brackets. Running a little math, it's clear that it there's no inherent difference between paying 20% of your earnings at retirement to Uncle Sam versus paying him 20% of each paycheck. Surprisingly, the remaining balance is identical in both cases!
So is the choice between traditional and Roth IRAs bogus? No; there are cases when one is preferable to other, although the differences are rarely as stark as we'd like them to be. The different becomes apparent when there's a different in tax bracket between one's working life and retirement.
Most middle-class retirees occupy a higher tax bracket during their working life than after retirement. At retirement, income level usually drops along with living expenses, with most retirees "coasting" off interest and capital gains from a saved up nestegg. In this case, a traditional IRA is more beneficial because taxes that would have been paid during one's working life (higher tax rate) are postponed until retirement (lower tax rate). The difference between this higher and lower rate is the amount saved by going with a traditional versus a Roth IRA.
On the other hand, some retirees face a different situation. Consider the case where one's tax bracket is higher at retirement than during one's working life. This is the case for many small business owners or high-income retirees who maintain a growing income stream during retirement. Those who've planned for retirement well often rent out a second home or earn dividends or royalties. For such retirees, a Roth IRA is preferable because the difference between past and current tax brackets is inverted, making it preferable to pay taxes upfront (lower rate) than after retirement (higher rate).
Traditional IRAs can be converted into Roth IRAs. However, all taxes that have been deferred on the contributions and the earnings will be due in the tax year of conversion. For most people, especially those who've built up large accounts over many decades, the opportunity to receive tax-exempt income from a Roth IRA is not worth the amount of tax that will be due.
Those interested in converting a traditional IRA into a Roth IRA should always make sure they understand how their marginal tax rates will be affected once they claim the distribution as income. For example, if the distribution pushes an account owner from the 25% marginal tax rate to the 28% rate, an additional 3% in taxes on the additional dollar amount in that bracket will be due. For some, this extra tax will offset any gains that will be made by receiving tax-exempt distributions in the future.
IRAs in Conjunction with an Employer-Sponsored Plans
When traditional IRAs were first introduced in the 1970s, they were intended to help those who were not covered by an employer-sponsored retirement plan save for the future. Along the way, workers who were covered by an employer plan, along with wealthier Americans, were allowed to establish IRAs.
While anyone with earned income can now fund a traditional IRA each year, not everyone can deduct the full amount. For example, a single taxpayer who participates in an employer-sponsored plan must have a modified adjusted gross income of $56,000 or less in order to fully deduct the amount he or she puts into a traditional IRA. A married couple that files jointly must have a modified adjusted gross income of $89,000 ore less to fully deduct the contribution.
Since contributions made to a Roth IRA are not tax-deductible, they are not dependent on an employer plan. However, Roth IRAs are not available for those who make what Congress deems to be a high salary. Single taxpayers who have a modified adjusted gross income of more than $122,000 are not allowed to fund a Roth IRA. Neither are married couples that file separately and have a modified adjusted gross income of more than $179,000.
The "Catch-Up" Contribution
Regardless of whether you choose a traditional or Roth IRA, if you turn 50 by the end of 2011, you are able to put an additional $1,000 into your IRA. This extra money is known as the "catch-up" contribution. Since 2001, those who are 50 years of age and older are allowed to contribute the additional money each year in order to help their accounts grow larger and faster.
Even if you can't fully deduct the amount you contribute to a traditional IRA, the money still grows on a tax-deferred basis until you begin to take distributions. For most Americans, especially those who are just now realizing they need to save more for retirement, catch-up contributions present another way to get retirement back on track.
While we've covered the basics of IRA investing here, there is much more to maximizing the success of you IRA. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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