Individual Retirement Arrangements (IRA), often called Individual Retirement Accounts, can be confusing because of the different rules that apply to the different types of IRAs. Understanding these rules is critical to determining which IRA is right for you. This article compares the two most popular types of IRAs, the traditional IRA and the Roth IRA.
A traditional IRA is available to most anyone under the age of 70½ with earned income. For 2012, you can contribute the amount of your earned income up to $5,000. If you’re age 50 or older you can make an additional “catch up” contribution of $1,000 of earned income, for a total of $6,000.
ADVANTAGES OF A TRADITIONAL IRA
1. Contributions may be tax deductible. Traditional IRA contributions are tax-deductible depending on whether you participate in an employer-sponsored retirement plan and if your income is below a certain threshold. If neither you nor your spouse participates in an employer-sponsored retirement plan, then your entire contribution is tax-deductible regardless of your income. If you participate in an employer-sponsored retirement plan, then your contributions are phased out if your adjusted gross income exceeds $58,000 for a single person or $92,000 for a married couple filing jointly. If your spouse is a participant in an employer-sponsored retirement plan but you are not, then a spousal contribution can be made for you even though you have no earned income, provided that your contributions are phased out if your spouse’s adjusted gross income exceeds $173,000 for a married couple filing jointly.
To the extent you are able to deduct contributions, every dollar you contribute to a traditional IRA is a dollar of income that isn’t taxed in the current year.
2. You defer taxes to a future date. The tax on your contributions and earnings in a traditional IRA are deferred until you withdraw the money. That’s an important consideration if you believe that you’ll earn substantially less taxable income during retirement than you do now and that you will be in lower income tax brackets during retirement.
3. You control when you’ll take distributions and pay the tax. You can begin taking taxable withdrawals from a traditional IRA once you reach the age of 59½, and minimum distributions must be made after you turn 70½. Distributions before 59½ are subject to a 10% penalty plus ordinary income tax unless certain exceptions are met. The exceptions to the 10% penalty include disability, medical expenses in excess of 7.5% of adjusted gross income, higher education costs and first time home purchase (with limitations). Having the ability to control when you pay tax on your IRA distributions allows you to make withdrawals when they benefit your overall financial and tax goals.
4. Your eligibility to contribute is not restricted. Unlike Roth IRAs discussed below, there is no limit on the amount of income you can earn to be qualified to contribute to a traditional IRA. Even if the contributions are not tax-deductible because your income is too high, you can still contribute on an after tax basis and obtain the benefit of tax deferrals on earnings in the account until you take the money out.
A Roth IRA has the same annual contribution limits as a traditional IRA (note that you are limited to a maximum of $5,000 (or $6,000 if over age 50) for either a traditional IRA or Roth IRA, or you can split the amount between the two accounts). A major difference between a traditional IRA and a Roth IRA is that a Roth is only available if you earn less than a certain amount based on your tax filing status. For 2012, the ability to contribute to a Roth IRA is phased out if your adjusted gross income exceeds $110,000 for a single person or head of household, or $173,000 for married couples filing jointly.
ADVANTAGES OF A ROTH IRA
1. Your investments grow tax-free (not just tax-deferred). Unlike traditional IRA contributions which may be tax-deductible, Roth IRA contributions are not tax-deductible. However, the account grows tax-free, unlike a traditional IRA where the tax is just deferred until withdrawal. There is no tax on contributions to a Roth IRA, earnings in the account or when you make qualified withdrawals.
2. You can make penalty-free withdrawals of contributions. Because you have already paid tax on the contributions, you can withdraw the contributions at any time without having to pay a penalty. However, withdrawing earnings from the account before age 59½ requires you to pay income tax plus a 10% penalty unless you meet one of the exceptions noted above for early withdrawals from traditional IRAs.
3. Roth IRAs have no age deadline. Unlike traditional IRAs, the Roth IRA has no age deadline. As a result, you can continue making contributions past the age of 70½ provided you still have earned income.
4. Not subject to minimum distribution rules. Unlike traditional IRAs where the account owner is required to take minimum distributions after age 70 ½, there are no required minimum distributions from a Roth IRA. This allows a Roth IRA account to continue to grow tax-free until you need it or until your death when it can benefit your heirs.
Converting a Traditional IRA to a Roth IRA
You can also get the benefit of a Roth IRA by converting a traditional IRA to a Roth IRA. There are no income limits to Roth IRA conversions, which expired in 2010, so anyone can convert a traditional IRA to a Roth IRA. Note that if a conversion is made, however, all of the taxes due on conversion in 2012 will be due by April 15, 2013.
Also note that because there are no longer any income limits on who can convert to a Roth IRA, the conversion rules may allow you to end up with a Roth IRA even if your income is too high to make a contribution directly to a Roth IRA. How is that possible? You can make nondeductible contributions to a traditional IRA and then later convert it to a Roth IRA. Because the contributions to the traditional IRA were nondeductible, there will only be tax due on the earnings in the traditional IRA prior to conversion above the amount of your original contribution(s). Keep in mind that if you have other IRAs, there are rules which require that each distribution from an IRA contain the same proportions of taxable and non-taxable assets as your total IRA balance (rollovers, SEP-IRAs, SIMPLE IRAs, etc.). In other words, you can’t cherry-pick which assets you want to convert. The rule is best explained with an example:
Let’s say that George has $100,000 in total IRA assets, $30,000 of which came from nondeductible contributions. Because of the pro-rata rule, any partial conversion will be considered 70% taxable and 30% tax-free, the same proportions as George’s total IRA balance.
Tax-Deferred vs. Tax-Free
The biggest difference between the traditional IRA and the Roth IRA is how the accounts are taxed. If you qualify for the deductibility of traditional IRA contributions, you will be able to deduct the contribution from your income taxes (meaning you will pay less tax on your earned income each year you contribute). At age 59 1/2, you may begin withdrawing funds, but you must pay income taxes on all of the capital gains, interest, dividends, etc., that were earned over the prior years.
By comparison, if you put the same contribution into a Roth IRA, you will not receive any income tax deduction in the year of contribution. However, when you reach age 59 ½, you are able to withdraw the funds in the account tax-free.
In summary, because of the ability to withdraw funds in retirement tax-free, a Roth IRA is going to be the preferred choice for many people. Unfortunately, as set forth above, not everyone qualifies for a Roth IRA based on income limitations. So, bottom line, most people will benefit by contributing to a Roth IRA provided that their adjusted gross income is below the limits set forth by the Internal Revenue Service. If you are unable to contribute to a Roth IRA because of the income limitations, you may still benefit from the tax deferral that a traditional IRA provides even if the contribution is not fully tax-deductible.