One of the most common and widely available investment tools for retirement is the individual retirement account. When it comes to choosing an IRA, there are two options: the traditional IRA and Roth IRA. You probably know something about each of these IRA options and understand the basic differences between them, but at the end of the day, you might still be wondering, “Which is best for me and my retirement plan?”
The traditional IRA. You can contribute a maximum of $5,500 annually in 2014, and if you’re age 50 and older, you contribute an extra $1,000, which is called a “catch-up contribution.” All contributions for the 2013 tax year must be made by April 15, 2014. These contribution limits and deadlines are the same for a Roth IRA as well.
The contributions you make to your traditional IRA may be tax deductible, depending on your income, tax filing status and participation in an employer-sponsored retirement plan.
For example, if you’re a single filer, an active plan participant and earn up to $60,000 a year, your IRA contributions are fully deductible. If your earnings fall in the $60,001 to $69,999 range, only part of your contribution is deductible, and anything over $70,000 is not eligible for a deduction. Any earnings accrued in this account are tax-deferred.
That covers the contribution part, but what happens when you reach retirement, and are ready to start taking withdrawals? Traditional IRAs offer you the benefit of tax-deferred growth, meaning you won’t pay taxes on your account until you begin making withdrawals. Keep in mind that if nondeductible contributions were made, each withdrawal is taxed.
The concept of tax deferment is appealing if you know you will have a lower income in retirement. This decrease in income could place you in a lower tax bracket, meaning that your withdrawals could be taxed at a lower rate. The appeal of tax deferment comes from the ability to have compounded gains over a prolonged period of time and not pay taxes on the gains. This is what makes the traditional IRAs a valuable tax management tool for individuals planning for their retirement.
Be cognizant of the fact that you cannot withdraw money before you reach age 59½, or you will be penalized 10 percent plus pay ordinary income taxes on any withdrawals made before that time. There are several exceptions to the early withdrawal rule. The most common are:
These exceptions are often referred to as Rule 72(t) provisions, as referenced in the Internal Revenue Code section 72(t).
Always remember that with a traditional IRA, you must take your required minimum distributions in the calendar year that you turn 70½, or you will be assessed a 50 percent penalty on the amount you should have withdrawn. Also keep in mind that these required minimum distributions are considered ordinary income and are subject to taxation. Required minimum distributions are an important factor to consider in retirement because they increase every year. As the owner of your IRA, you typically have greater control over the account investments.
Roth IRA. Contributions that are made to a Roth IRA are made with after-tax dollars (none of your contribution is tax deductible), so withdrawals from the amount contributed are always tax-free. This is the main difference between the traditional IRA and Roth IRA.
The same contribution rules that apply to traditional IRAs also apply to Roth IRAs. There is a $5,500 annual contribution, and those age 50 and older pay an extra $1,000. Accrued earnings can also be withdrawn free of tax after they have been held in the account for more than five years.
It’s important to keep in mind that your ability to contribute to a Roth IRA is contingent on your income.
You cannot make contributions if your income exceeds $129,000 (single) or $191,000 (joint). If investors reach those limits in a given year, they have the ability to recharacterize their contributions to a traditional IRA without penalty, as long as it’s completed by the tax filing deadline for that tax year. Your ability to contribute to a Roth IRA is not affected by your participation in an employer-sponsored plan.
Unlike the traditional IRA, all qualified distributions from a Roth IRA are tax-free. In order for a distribution to be considered qualified, it cannot be taken out until five years after you set up your Roth IRA, the owner is age 59½, using the withdrawal to make a first-time home purchase ($10,000 limit), becomes disabled or dies, in which case the beneficiary collects. The importance of tax-free qualified distributions cannot be understated, and that makes the Roth IRA a very attractive vehicle for retirement savings.
Kelly Campbell, certified financial planner and accredited investment fiduciary, is the founder of Campbell Wealth Management and a registered investment advisor in Alexandria, Va. Campbell is also the author of “Fire Your Broker,” a controversial look at the broker industry written as an empathetic response to the trials and tribulations that many investors have faced as the stock market cratered and their advisors abandoned their responsibilities to help them weather the storm.