By Elizabeth Paal, CFP®, CRPC®
As promised last month, today I will dive into the difference between the Traditional IRA versus a Roth IRA. Individual Retirement Accounts (IRA) were originally developed for workers and their families who did not have an employee-sponsored retirement plan, but they have become a valuable tool for most individuals.
What distinguishes a Traditional IRA from a Roth IRA is the tax treatment of the money invested. With a traditional IRA, the contributions to the account may be tax-deductible, but deductibility depends on your income and the earnings grow tax-deferred until withdrawn. Withdrawals prior to 59.5 years of age may be subject to a 10 percent federal income tax penalty and state income taxes (if applicable).
With a Roth IRA, there is no deduction for your contributions and earnings can grow tax-free. After 59.5 years of ago, and if the account has been open for five years, earnings are tax and penalty free.
Another distinguishing factor about a Traditional IRA is that you are required to begin withdrawing money beginning the year after you turn 70.5 years old. The amount that must be withdrawn is referred to as a RMD (Required Minimum Distribution). Your financial advisor or CPA can help you compute this figure each year. It is factored using a life expectancy table, and the divisor gets larger as one gets older.
With a Roth IRA, there are no Required Minimum Distributions. Many people see this as a perk if they choose to work into their 70s and do not want to take any additional income for the year.
Your income may determine your choice of going with a Traditional or Roth IRA. In 2016, each individual can contribute up to $5,500 into either plan, with an additional $1,000 if they are 50 years old or more. To fully participate in a Roth IRA, single filers must have a modified adjusted gross income of less than $132,000, or filed jointly with less than $194,000 in 2016.
There are no income caps for Traditional IRAs, but filers with higher modified adjusted gross incomes will lose the deduction benefit (over $71,000 for singles or $118,000 for married filing jointly). In both cases of the Roth IRA and Traditional IRA, the law enables these limits to be indexed over time.
Calculating which IRA will benefit you involves factoring in age, income and the expected rate of return. We usually see it more beneficial for younger individuals to contribute to a Roth IRA because they have decades of compounded growth on their investments, which one day will be taken out tax-free. It is also assumed that younger individuals are earning less now than they will be in their retirement years, and taxes will likely be higher during their retirement years.
It is prudent to ask your financial advisor to compare the two types for you so you can make an informed decision. It’s also a good idea to consult with your CPA as well, to ensure you fall within the income limits before making a contribution to one of the plans.
If you have earned a bonus for your hard work in 2015, think about adding a portion of that into an IRA. You have until April 15 (tax day), to establish and contribute to a plan for 2015.
As always, please feel free to contact me with any questions at Elizabeth.Paal@LFG.com. Elizabeth Paal is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. CRN-1433928-030216