As fellow U.S taxpayers, deciding on where to put your money today can have long term implications when it comes to taxes. Depending on your situation, a ROTH or a Traditional IRA may be appropriate. The objective of this article is to help explain the differences.
Anyone with earned income, who is younger than 70 ½, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions: In 2014, the schedule for married taxpayers filing jointly is $181,000-191,000; for Single and Head of Household filers, it's $114,000-129,000. Individuals with incomes above the top number in each category cannot contribute to a Roth IRA, directly.
Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with traditional IRAs, you delay taxes when you put the money in. With Roth IRAs, you can avoid taxes when you take it out in retirement.
Which is better? It depends; if you expect your income to be higher in retirement, then a Roth IRA may be the way to go. Also, some economists predict, given today’s historically low federal tax rates and a large U.S. deficit, that tax rates will rise in the future – making the Roth IRA more appealing.
What if I’m earning too much and can’t contribute to a Roth IRA?
The current tax code allows high income earners to possibly fund a Roth IRA using a “backdoor IRA” strategy. Here’s how you may be able to do it:
In summary, if all of your retirement money is tied up in your 401k or traditional IRA, make sure you are factoring in taxes when it comes to your retirement savings. If you need a hypothetical $150,000 annually in retirement to sustain your lifestyle and you pull that out of a 401k or Traditional IRA – you will pay ordinary income taxes – so you’ll need to pull out much more than $150,000. If you pull out $75,000 from your 401k and $75,000 from a Roth IRA – you’ve effectively cut your income in half, because the Roth IRA money can be accessed tax free – making your taxable income only $75,000. Diversification is not only important when it comes to investing, but just as important when it comes to retirement tax preparation.
It is important to keep in mind that for a Roth IRA, earnings withdrawn prior to reaching age 59½ and/or not meeting the five-year holding period may be subject to a 10 percent penalty in addition to income tax. After-tax contribution amounts are generally returned income tax free; however, for Roth conversions, if converted amounts are not held for the five-year period, distributions may be subject to a 10 percent penalty.
Written by Tanner Fedell, Financial Advisor
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