Which IRA Is Right for You?
Traditional vs. Roth IRAs
by Glenn Swift
Individual Retirement Accounts (IRAs) are some of the most popular tax-advantaged retirement savings vehicles available. It’s not hard to understand why. They are simple to open and easy to manage. However, some novice investors believe that an IRA is a specific type of investment. It’s not. In fact, the IRA account itself is just a shell: you select one or more investments to fill it.
An essential component to understanding IRAs is to know that not all of them are alike. In fact, both types of IRAs differ from each other in a number of ways. Therefore, to make a prudent decision as to which IRA is right for you, it is necessary to understand the key characteristics of each.
Traditional IRAs allow a working individual under the age of 50 to contribute up to $5,500 of compensation each year; the contribution limit increases to $6,500 if you’re over 50 by taking advantage of the so-called “catch-up provision.” Please note that once you reach age 70½ you can no longer contribute to your IRA and must begin taking withdrawals. In addition, married taxpayers under the age of 50 filing jointly can contribute up to $11,000 ($5,500 per IRA) even if only one spouse has earned income (spousal IRA). For a couple over 50, the maximum contribution increases to $13,000 annually.
All earnings in a traditional IRA accumulate tax-deferred, meaning that they are not taxed until withdrawn. Contributions may also be deductible depending upon the account owner’s adjusted gross income, tax filing status, and whether the participant is already covered by an employer-provided retirement plan. (For specific details as to the deductibility of contributions, visit www.irs.gov/Retirement-Plans/IRA-Deduction-Limits.)
Withdrawals are subject to ordinary income tax and may be subject to a 10% federal penalty tax if taken prior to age 59½. The 10% penalty is waived for distributions related to the following circumstances:
- You become permanently disabled
- You have unreimbursed medical expenses exceeding 10% of your Adjusted Gross Income (AGI)
- You pay qualified higher education expenses
- You use the funds for a qualified first-time home purchase
- You use the funds to satisfy an IRA levy
- You pay medical insurance premiums while unemployed
- You receive the withdrawal as part of a series of substantially equal periodic payments over your life based upon life expectancy
- Your funds are paid to a beneficiary or to your estate on account of your death.
Contribution limits are the same for Roth IRAs as those for Traditional and Non-Deductible IRAs. In addition, contributions to a Roth IRA are made with after-tax dollars and early withdrawals of earnings are subject to the same 10% tax penalty. However, the major difference here is that withdrawals of earnings are federal income tax-free if they are taken five years after the first contribution was made to the account—and after you have reached age 59½. Another advantage of the Roth IRA is that there is no age at which the account owner must begin taking distributions. In other words, if you are beyond age 70½ and have earned income, you may still be eligible to contribute to a Roth IRA. Moreover, with a Roth IRA your contributions are always liquid. In other words, you can take your contributions out at anytime without penalty (regardless of your age). For those account holders not yet 59½, you can also take out your earnings without incurring the 10% tax penalty if the funds withdrawn are related to the circumstances listed above for the same purpose with Traditional IRAs.
One further note about Roth IRAs… If you file singly, as head of a household or you are married filing separately and did not live with your spouse at any time during the calendar year and your Adjusted Gross Income (AGI) is more than $127,000, you are NOT eligible to open a Roth IRA. In addition, if your AGI is more than $166,000 and you’re married and filing jointly, you are NOT eligible to open a Roth IRA. (For more details on eligibility, visit www.irs.gov/Retirement-Plans/Roth-IRAs.)
More about IRAs…
Investment Options: A wide range of investments are generally available for IRAs at most large financial institutions, and contributions can be easily made through automatic deductions from a checking or savings account.
Restrictions: Some types of investments are not permissible: (e.g., collectibles, real estate, and life insurance). In addition, some types of transactions are also prohibited (e.g., using an IRA account as collateral for a loan).
Determining which IRA is best for you is a complex decision and depends upon a number of factors: your current tax bracket, the amount of years you will be making contributions, and your anticipated tax bracket upon retirement. Before making your decision, it is highly recommended that you consult with a trusted advisor.
Term or Whole Life?