Traditional and Roth IRA’s
The theories discussed stem from The Truth About Retirement Plans and IRAs by Ric Edelman
Individual Retirement Accounts (IRAs)
This article will highlight two individual retirement vehicles, the Traditional and Roth IRA.
Both accounts are offered by the Federal government as means to help lower and middle class individuals better prepare for their future. Annual contribution limits are set by the IRS. Surprising annual contribution limits is around a 10% year tax penalty administered by the IRS until the excess is removed Check the Internal Revenue Service website or consult a professional if your are unsure of personal finance strategies.
Opening an IRA means you are creating an agreement with the IRS and will obey certain restrictions in exchange for tax benefits. Reneging on the restrictions results in tax penalties. The restrictions and benefits are detailed in the chart below.
The IRS does allow certain circumstances in which contributions are allowed to be withdrawn from IRA’s before the age of 59 1/2 without any penalty. These exceptions include the birth of a first child and purchasing a first home.
It is important to note that both accounts are managed by custodians, such as commercial banks and retail brokers (Schwab, Vanguard, Fidelity etc.). Investors can purchase stocks, bonds, CD’s, and other financial assets within these accounts.
Contributions to a Traditional IRA, and the growth of it through returns on investments and compounding interest are tax-deferred. These contributions are often considered pre-tax dollars. Taxes will not be owed until the money is withdrawn and contributions to this account may be tax-deductible. However when you do decide to withdraw, contributions and earnings will taxed at at tax bracket rate you fall in at that point in time.
The logic being potential tax benefits now (the year of contribution) and delaying the taxation until you are ready to have the funds distributed. Although the individual must be at least 59 1/2 to be eligible for penalty-free withdrawals.
Traditional IRA’s are the better option if you plan on being in a lower tax bracket at retirement than your current tax bracket.
A plethora of rules and regulations exist to govern IRA’s but an important designation of the Traditional is income levels do not affect contributions limits. $5,500 for those under 50 and $6,500 for those older than 50 are the maximums. Although you cannot contribute more than you report to the IRS as employee compensation.
Contributions to a Roth IRA and growth are tax-sheltered and made from after-tax dollars. This essentially means pay taxes now and owe the IRS nothing at withdrawal.
The logic being pay taxes on income now, let contributions grow and than withdraw with no taxes owed. It does not matter what tax bracket you fall in at retirement, as taxes have already been paid. Although the account must be at least 5 years old you must be at least 59 1/2 to be eligible for penalty-free withdrawals.
Roth IRA’s are the better option if you plan on being in a higher tax bracket at retirement than your current tax bracket.
The Roth also employs a sliding scale of contributions limits. High income individuals earning an AGI (Adjusted Gross Income) of $116k to $131k are able to contribute a reduced amount. Individuals earning over $131k are unable to contribute.
Roth’s are also inheritable. Inherited Roth’s have their own set of regulations and distribution minimums but this is an interesting caveat. It means you could put a few thousand away, with plans on not touching the fund (or at least not all of it) and passing it down to a spouse or child. This allows a significant time horizon for compounding interest to compile and also provides a tax-free vehicle.
|Tax benefits||Tax-free growth and withdrawals||Tax-deferred growth and tax deductible contributions|
|Eligibility Age||Any age with employment||Under age 70 1/2 with employment|
|Eligibility Income||See IRS website for married/joint filing statuses. Below are the rates for single, head of household, or married individuals filing separately
< $116,000 = limit
> $116,000 but < $131,000 = a reduced amount
> $131,000 = none
|Taxation at withdrawal||Earnings are federally tax-free after the account is five-years old and the individual aged 59 1/2
Contributions are always withdrawn tax-free
|Withdrawals of pre-tax contributions and any earnings are taxable when distributed after the individual is aged 59 1/2|
|Penalties||A non-qualified distribution is subject to taxation and a 10% additional tax unless an exception applies. Exceptions include First Child, First Home Purchase but need to be verified with the IRS.||Withdrawals before 59 1/2 may be subject to a 10% early withdrawal penalty unless an exception applies.|
|Minimum required distributions||None ( recently read Obama is backing legislation to change this)||Starting at 70½ individuals need to begin withdrawing from the account|
|Maximum contribution||$5500 ($6500 if you are 50 or older) or 100% of employment compensation, whichever is less||$5500 ($6500 if you are 50 or older) or 100% of employment compensation, whichever is less|
|Catch-up||Individuals age 50 or older can contribute an additional $1000 a year||Individuals age 50 or older can contribute an additional $1000 a year|
|Contribution Deadline (set by IRS annually)||April 15||April 15|
|Minimum to Open||None||None|
Which vehicle is best for you?
The key question to ask yourself when deciding between a Roth or Traditional IRA is; Will my income be higher or lower at retirement? If higher Roth may be the better option, if lower Traditional may be the best decision.
For example, for a 22 year old being paid minimum wage, the 22 year old would more than likely fall in a higher tax bracket at retirement. For him, the Roth is the better option. For a 34 year old making 80k a year, the better option may be the Traditional IRA. Again the key question being expected taxable income levels at age of retirement.
It is also possible to own both a Traditional and Roth, but cumulative contribution limits remain at $5500 for individuals under 50.
Overall maximizing retirement income is not straightforward. Social security and pension need to be considered to maximize retirement income. Legislation is also subject to change, and I have read speculation that Obama hopes to dilute the Roth. Hopefully he’s out before legislation is enacted, but time will tell.
Sources: Internal Revenue Service, Fidelity Investments, The Truth About Retirement Plans and IRAs by Ric Edelman