TRADITIONAL VS. ROTH IRA IRA’s, otherwise known as an individual retirement accounts, were established by legislation approved by Congress in 1974. Their purpose was to promote saving for retirement in an effort to ease some of the burden on the Social Security system. There are two commonly known kinds of IRA’s. There is the traditional IRA, which is the original form, and there is the Roth IRA, which was established with the Taxpayer Relief Act of 1997. There are different reasons for investing in each, and those will be summarized below. ** For a complete list of rules and explanations regarding IRA’s, visit the IRS website at www.irs.gov and type Publication 590 into the search box at the top right. This publication is free and provides ~104 pages of guidance on IRA’s and is updated annually. Rules Applying To Both - Contributions limited to $4,000 per year per individual under age 50 - Individuals over age 50 are allowed to contribute up to $5,000 per year - If your taxable income for the year is less than the amounts above, you are limited to contributing the lesser of the two - You normally cannot make a withdrawal until you are age 59½ without incurring a penalty or paying taxes on that withdrawal
Traditional IRA - Contributions made are generally tax-deductible o Whether you are able to deduct your contributions depends on three things Whether you or your spouse are covered under an employer sponsored retirement plan Your tax filing status Your gross income for the year o You are generally considered to be covered under an employer sponsored retirement plan if your employer offers one, even if you did not participate or have no legal right to the benefits in the plan - - if your company offers a TSP, 401(k), money-purchase plan, pension plan, stock-bonus plan, or any other form of defined benefit or defined contribution plan o If you are a Reservist, you will not be considered covered under that plan if the plan you participate in is established by the U.S. or an individual state, and you did not serve more than 90 days active duty (not counting duty for training) o Reference table 1 below for determining whether or not you are eligible to deduct your contributions - All earnings in your account are tax-deferred, meaning you do not pay taxes on them until you begin making withdrawals from your account - Contributions cannot be made to your account for any year in which you turn 70½ or later
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You must begin receiving required minimum distributions by April 1 st of the year following the year in which you turn 70½ Distributions are taxed as ordinary income Table 1
Covered By Employer Plan
Not Covered By An Employer Plan
Roth IRA - Contributions are not tax-deductible - Earnings on the account are tax-free - Qualified withdrawals are tax-free - You are not required to begin taking distributions at any age - There is no age limit on contributing - Your may not be allowed to contribute, or contributions might be limited if you are… o Married filing jointly with combined income over $150,000 o Married filing separately and lived with your spouse anytime during the year with income between $0 - $10,000 o Single, Head of Household, or Married filing separately and did not live with your spouse anytime during the year, with income over $95,000 $110,000
Spousal IRA - A spousal IRA can be established for a non-working spouse - The account must be in the name of the non-working spouse - For all practical purposes, this account falls under the same set of rules as a regular traditional or Roth IRA - The working spouse may make contributions within the specified limits to this account
Which Should I Invest In? The answer is, it depends. Things to consider are whether or not you make too much income to contribute to a Roth, and if you do, will you be allowed to deduct your contributions to a Traditional. Next you might want to consider the benefits of each account. If you will be funding your retirement with other resources, such as a large inheritance, you might prefer not to be required to take mandatory distributions, or you might want to continue making contributions beyond age 70½. One of the biggest considerations to factor in is a tax bracket. Do you know which bracket you are in? Do you know which bracket you will be in when you retire? Table 2 displays the tax brackets for the 2006 tax year. Table 2 – Tax Brackets (2006) Married Filing Jointly
$0 - $15,099 $15,100 - $61,299 $61,30 - $123,699 $123,700 - $188,449 $188,450 - $336,549 > $336,550
Single
$0 - $7,549 $7,550 - $30,649 $30,650 - $74,199 $74,200 - $154,799 $154,800 - $336,549 > $336,550
Married Filing Separately
$0 – $7,549 $7,550 - $30,649 $30,650 - $61,849 $61,850 - $94,224 $94,225 - $168,274 >$168,275
Head of Household
$0 - $10,749 $10,750 - $41,049 $41,050 - $105,999 $106,000 – $171,649 $171,650 – $336,549 >$336,550
BRACKET
10% 15% 25% 28% 33% 35%
Most married individuals in the military fall within the 25-28% tax brackets. Single individuals in the military will generally be within the 15-25% brackets. Since everyone in the military is covered under the TSP, regardless of participation, contributions to a traditional IRA may not be fully deductible depending on your income and filing status. Generally, if you cannot deduct your contributions to a traditional IRA, it is better to contribute to a Roth IRA. Your contributions to a Roth IRA are not limited until you are making a much higher income than the limit affecting traditional IRA deductions. There are no special, or other sets of limits affecting contributions to a Roth IRA if you are a participant in your TSP, 401(k), or other employer sponsored retirement plan. Assuming you are able to deduct your full traditional IRA contributions, you still have other factors to consider. If your adjusted gross income just barely falls within the range of a higher bracket, then contributing to a traditional IRA will reduce your income and place you in a lower tax bracket, offering you a chance to save on taxes.
For example, if Bob is single and earned $32,000, he is currently in the 25% tax bracket, but since he is able to take a full deduction for contributions to a traditional IRA, he contributes $2,000 for the year. This $2,000 deduction will reduce his adjusted gross income to only $30,000, which places him in the 15% tax bracket, and saves him 10% on taxes for the year.
Another factor is what tax bracket you will be in when you retire. Generally, most individuals will be in a lower tax bracket when they retire since they are making less taxable income. If this is the case, by contributing to a traditional IRA you are deferring paying taxes on your earnings until you are in a lower tax bracket, so if you can contribute and take the full deduction in this year, then you should. You have probably heard arguments over which account will be worth more but what is the real answer. Let’s assume you are in the 28% tax-bracket, you can deduct all of your contributions if you used a traditional IRA, and you will be in the same tax-bracket at retirement. If you made equal contributions, the accounts will be worth exactly the same after taxes are paid on the traditional when you retire. A traditional will only be worth more if your tax bracket is lower during retirement. Does this mean it is the right choice? Well, like I said, that depends. Given the explanation above, if you take a few minutes to analyze your income, filing status, employer-plan participation status, retirement taxbracket, and flexibility of options at retirement, you will discover the right option for you.
QUICK CALCULATOR - - WHICH IS RIGHT FOR YOU? Locate your tax filing status and then answer the questions to help determine which IRA is right for you. Each question is color-coded to make it easier to choose your answer. SINGLE or HEAD OF HOUSEHOLD Are you covered under a work-plan, such as a 401(k), TSP, 403(b), etc…? Yes: Do you make more than $50,000 a year in gross income? Yes: You are probably better off contributing to a Roth IRA, since you may not be eligible to deduct all of your contributions to a traditional IRA. Will you be in a lower tax-bracket during retirement? Yes: No: A traditional IRA is probably the best choice for you. Contributing to a traditional IRA will save you on taxes right now, but it will be worth the same amount as a Roth when you retire since you will pay taxes on your withdrawals. If you prefer being able to contribute past age 70 ½ and don’t want to be required to take mandatory distributions, you should use a Roth.
No:
No:
Contributing to a traditional will lower your gross income in this year since your contributions are fully deductible. If you prefer to pay lower taxes now because of the deductions and think you will be in a lower taxbracket during retirement, then a traditional IRA probably is the best choice for you.
MARRIED FILING JOINTLY Are you covered under a work-plan, such as a 401(k), TSP, 403(b), etc…?
Yes:
Do you and your spouse combined make more than $70,000 a year in gross income? Yes: You are probably better off contributing to a Roth IRA, since you may not be eligible to deduct all of your contributions to a traditional IRA. Will you be in a lower tax-bracket during retirement? Yes: No: A traditional IRA is probably the best choice for you. Contributing to a traditional IRA will save you on taxes right now, but it will be worth the same amount as a Roth when you retire since you will pay taxes on your withdrawals. If you prefer being able to contribute past age 70 ½ and don’t want to be required to take mandatory distributions, you should use a Roth.
No:
No:
Is your spouse covered under a work-plan, such as those listed above? No: There is no limit to the income you both make, your contributions are fully deductible to a traditional IRA and it will probably be the best choice for you. Do you and your spouse combined make over $150,000 a year? Yes: You make too much money to contribute fully to a Roth IRA, but you also make too much to be able to deduct your contributions to a traditional IRA. If you want to reduce your taxes, contribute to your work-plans, they will provide a better investment than a traditional IRA. Your contributions to a traditional IRA are fully deductible, however, if you and your spouse earn over $70,000 a year, your spouses contributions to a traditional IRA will not be fully deductible.
Yes:
No:
MARRIED FILING SEPARATELY Are you covered under a work-plan, such as a 401(k), TSP, 403(b), etc…? Yes: Do you make more than $10,000 a year? Yes: You are not eligible to deduct your contributions to a traditional IRA, and you are not eligible to contribute to a Roth IRA. If you want to reduce your taxes, contribute to your work-plans, they will provide a better investment than a traditional IRA. You might also consider changing your tax filing status. Your contributions to a traditional IRA are only partially deductible, but you also are limited to your contributions to a Roth IRA. If you want to reduce your taxes, contribute to your workplans, they will provide a better investment than a traditional IRA. You might also consider changing your tax filing status.
No:
No:
Is your spouse covered under a work-plan, such as those listed above? No: There is no limit to the income you both make, your contributions are fully deductible to a traditional IRA and it will probably be the best choice for you. Do you make over $10,000 a year? Yes: You make too much money to contribute fully to a Roth IRA, but you also make too much to be able to deduct your contributions to a traditional IRA. If you want to reduce your taxes, contribute to your work-plans, they will provide a better investment than a traditional IRA. You might also consider changing your tax filing status. Your contributions to a traditional IRA are only partially deductible, but you also are limited to your contributions to a Roth IRA. If you want to reduce your taxes, contribute to your work-plans, they will provide a better investment than a traditional IRA. You might also consider changing your tax filing status.
Yes:
No: