Money And Investing  -

Roth IRA vs. Traditional IRA

28 02 06 24 19

-------- One, the other, or both?

(Retire at 30 is hosting this week's Carnival of Investing. Their Go With Roth story served as inspiration for this article.)

A very common question that people ask themselves is if they should invest their money in a Roth IRA or in a Traditional IRA. As with many things in life we may initially be inclined to say it depends. However, upon further examination we do notice that for most people the best answer could be to have both.

First let’s review the benefits and limitations of each option:

• Traditional IRA – Potential tax refund now, and future taxes (when distributed) over both: the tax-deferred contribution and the gain. However, the tax deferral on the principal deposited is subject to limitations based on your modified adjusted gross income (If covered by a retirement plan at work, phases out between 50K and 60K if single, and 75K and 80K if married filing jointly. If not covered, it is unlimited for singles, but phases out between 150K and 160K of modified adjusted gross income).
  If you need the tax reimbursement money now, this type of IRA may be your best option. Also remember that before April 15th you can contribute to an IRA for the previous year. Some people use the tax refund for IRA contributions: essentially funding part of their contribution with the increased refund caused by declaring an IRA contribution.
  People with high tax brackets now, who expect to have low tax brackets in the future, benefit the most with this type of IRA. However, due to the adjusted gross income thresholds, many people in high tax brackets are disqualified from the tax deductions associated with Traditional IRA contributions.
• Roth IRA – You contribute after-tax money today, but any earnings are extracted tax free if used after the intended age. All of the compounding: capital appreciation, dividends, and interest is tax free! That is a great deal that Uncle Sam treats us to. Plus, it may be your best alternative if you have access to a retirement plan at work. Your can contribute as long as your modified Adjusted Gross Income is $110,000 or less if you are single, or up to $160,000 if married filing jointly.
  People with low tax brackets now benefit the most with this type of IRA.

The missing truth: What most people don’t tell you:
Not all the money you earn is taxable anyway. When you reach your retirement age after 59.5 years, and you take money out in the form of distributions, you will pay taxes on the money taken out of a Traditional IRA that, together with other sources of income, exceeds your personal exceptions, and deductions. On top of that you may even get credits for some reasons. Any money exceeding $8,200 for singles, or 16,400 for married filing jointly (personal exception + deduction) is federally tax free anyway. Wouldn’t it be nice to get that money out of a Traditional IRA where you never paid taxes on the way in, or on the way out? Even if you have to pay taxes on the money above those amounts, the first couple of tax brackets are taxed at 10 and 15%, not a big amount of money.

$10,000 or $15,000 (in today’s money) is not enough to live comfortably. There will be mounting medical bills as you approach your golden years (sometimes deductible from taxes), and you don’t want to live miserably. Furthermore, there may be some income you get from other sources that may eat into your “tax free allowance” or even your “10% and 15% tax bracket allowances”. That’s where the Roth IRA comes to the rescue. The money to be taken above those allowances that Uncle Sam gives us is better taken out of a Roth IRA.

You should consider having both types of accounts, according to the tax benefits needed, and the expected amounts you will need in the future, taking into special consideration the tax free and low tax allowances Uncle Sam offers. On most situations, you may want to favor Roth type accounts, due to their tax free benefits.