In the blue corner we have the old champ: a possibly-tax-deductible, retirement plan whose contributions and earnings are tax-deferred. Weighing in as a heavyweight retirement planning tool at age 38 (created in 1974), made famous as part of the Employee Retirement Income Security Act (ERISA), please welcome the Traditional IRA.
I apologize if you don't care for my boxing commentary, but I wanted to be sure to make a point about how financially significant the choice between a Roth IRA and a Traditional IRA can be for an individual. There are other types of IRAs, but these two are by far the most common. I’ve briefly summarized the differences and glossed over the technicalities between a Roth IRA and a Traditional IRA and a Roth 401(k) and a Traditional 401(k) in previous blog posts, but the time has come for us to hammer this out. By the end of this post, it’s my goal that you will be able to make an informed decision about which type of IRA will better suit your personal preferences and cash flow needs, without wanting to throw in the towel. Here goes:
- Roth IRA starts the round by offering that you may contribute the smaller amount of $5,000 a year ($6,000 if you are 50 years of age or older by the end of 2012) or 100% of your 2012 taxable compensation (if your compensation is less than $5,000) to a Roth IRA.
- Traditional IRA parrys with the exact same offering that you may also contribute the smaller amount of $5,000 a year ($6,000 if you are 50 years of age or older by the end of 2012) or 100% of your 2012 taxable compensation (if your compensation is less than $5,000).
- Roth IRA submits that your contributions are not tax deductible, but counters that your contributions and any investment earnings will not be taxed when you withdraw your funds.
- Traditional IRA lands a jab since your contributions may be deductible if your Modified Adjusted Gross Income is less than $58,000 if you file your taxes as an individual or less than $92,000 if you file as married filing jointly.
- Traditional IRA was gloating a little when it was almost knocked down after having to acknowledge that whether you are eligible for a deduction or not, your contributions and any investment earnings will be taxed when you withdraw your funds.
- Roth IRA continues the assault by pointing out that you never have to take mandatory distributions, and if you so choose, you will be able to make tax-free withdrawals after you turn 59 ½.
- I think it's important to add that you’re actually allowed to withdraw “contribution dollars” (what you have put in, not earnings) at any point after you have held the Roth IRA for at least five years.
- Traditional IRA may be on the ropes here, because if you contribute to a Traditional IRA, you will have to start taking required minimum distributions by age 70 ½, but at least you will be able to make penalty-free withdrawals after you turn 59 ½.
- Just to be fair, I should also add that any withdrawals you make before 59 ½ (including “contribution dollars”) are subject to tax and a 10% penalty, unless a few, certain exceptions apply.
- Just when you think Roth IRA has this fight won, you learn that you are not allowed to contribute to a Roth IRA if your Modified Adjusted Gross Income is greater than $125,000 if you file your taxes as an individual or greater than $183,000 if you file as married filing jointly.
- Please note there is an income phase out.
- Traditional IRA has landed quite a hook by proving that there is no income limit on being able to make a contribution.
- As the fight draws to a close, Roth IRA gets in one last cross as it reminds us you can contribute at any age.
- Traditional IRA heads to the corner knowing you are not allowed to contribute to a Traditional IRA after you reach the age of 70 ½.
That's it! The fight is over.
I wish I could tell you the absolute winner, but unfortunately I can't always do that without knowing your particular financial situation. If you're still not sure who should have the lead on your scorecard, just remember: Roth contributions are not tax deductible, and the withdrawals are tax free; Traditional contributions could be tax deductible, and the withdrawals are taxable.
Before I sign off, let me briefly mention 401(k)s. You might recall from my previous post, “401-OK,” that some companies are allowing employees to choose between making Roth, or after-tax 401(k) contributions, and Traditional, or pre-tax 401(k) contributions. Well, the takeaways from above are about the same for 401(k)s. Just remember, Roth 401(k) contributions are made with after-tax money and the withdrawals are tax free; Traditional 401(k) contributions are made with pre-tax money, come with no possible deductions (unlike a Traditional IRA), and the withdrawals are taxable. You also might find this Charles Schwab 401(k) Calculator comparison useful in determining the best choice for your particular financial situation.
I know this was one of my more technical posts, and as always, I’m happy to help if you have questions. Try to look on the bright side; at least this Roth vs. Traditional bout was not Pay Per View.
Good advice, Tom! One more thing to add.. there are some overly cynical, paranoid people (ie, me) that think its possible that the government will end up deciding many years down the road to start taxing Roth IRA earnings. Who knows what will happen, though!ReplyDelete
I have heard rumblings of your fear as well, but I would not worry too much. Making Roth IRA earnings taxable would require years of transition as certain income tax laws would have to be repealed and alternatives would have to be passed. I would also offer that it would be much easier for Congress to make tax rates in the future higher than they are now. That would actually make a Roth IRA more attravtive as you would be paying lower taxes on Roth IRA contributions now as opposed to higher taxes on Traditional IRA contributions and earnings in the future. Like you said though, I wouldn't begin to claim to know what Congress is and is not going to do!Delete
Tom, I've read that you can still slip money into a Roth IRA if your income is above the maximum allowed by putting it in a Traditional and then converting to a Roth. This will allow your earnings to be tax-free. Do you know anything about this? I enjoy reading your blog because it brings humor to a boring subject.ReplyDelete
You are correct that high-income taxpayers can essentially make Roth IRA contributions by contributing to a Traditional IRA and then converting it to a Roth. While this can be an effective strategy in some cases, it is not always a winner if you have additional Traditional IRA assets beoynd your current year contribution. This is because of a pro rata tax rule that basically requires you to ratably pay taxes on your entire Traditional IRA account's earnings when you convert, not just the taxes on your current year contribution. In English, check with your CPA or financial planner before you think about implementing this strategy. It's doable, but not as simple as you might think.Delete
For a more detailed example, you may also find this article helpful:
Thanks for the compliment. I do my best to provide advice that is actually helpful and won't put you to sleep.