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Traditional and Roth IRA

Traditional and Roth IRAs can play a major roll in building wealth for your future.  As an investor, it is important for you to understand the features and benefits of an IRA. 

The type of individual retirement account you choose can significantly affect you and your family’s long-term savings. So it’s worth understanding the differences between traditional IRAs and Roth IRAs in order to select the best one for you.

 

Income Limits

Anyone with earned income, who is younger than 70 ½, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions: Single tax filers, for instance, must have modified adjusted gross incomes of less than $133,000 in 2016 to contribute to a Roth IRA. (Contribution limits are phased out starting at $117,000 in modified AGI, per IRS guidelines.) Married couples filing jointly must have modified AGIs of less than $194,000 in 2016 in order to contribute to a Roth; contribution limits are phased out starting at $184,000. 

Tax Incentives

Both traditional and Roth IRAs provide wonderful tax breaks. But it’s a matter of timing when you get to claim them.  Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. Having the ability to withdrawal money from Traditional and Roth IRAs can be an invaluable strategy in retirement. 

 

Future Tax Rates

As we all know, it’s hard to predict what federal and state tax rates will be 10, 25 or even 40 years from now. But you can ask yourself some basic questions to help determine your personal situation: Which federal tax bracket are you in today? Do you expect to your income including Social Security to increase or decrease in retirement? Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not.  Deciding to contribute to a traditional or Roth IRA should depend on whether you expect your income tax rate in retirement to be higher or lower than what you currently pay. That’s because it determines whether the tax rate you pay on your Roth IRA contributions (today’s tax rate) is higher or lower than what you’d pay on your traditional IRA’s withdrawals in retirement.

 

 

 

Withdrawal Rules

One major difference between traditional IRAs and Roth IRAs is when the savings must be withdrawn. You will be required to start taking required minimum distributions (RMDs) from Traditional IRAs at age 70 1/2, regardless if you need the money or not. RMDs are calculated using the IRS Uniform Life Table. Subsequently, there is no mandate to take withdrawals from a Roth IRA during the owner’s lifetime. So, if you don’t need the money, Roth IRAs can continue to grow tax-free throughout your lifetime, making them ideal wealth-transfer. As of 2015, beneficiaries of Roth IRAs don’t owe income tax on withdrawals and can stretch out distributions over many years.

Both traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59 ½. However, Roth IRAs require that the first contribution be at least five years before qualified distributions begin.

It’s also worth factoring in some of the specific rules and benefits of traditional and Roth IRAs. Here’s a breakdown:

Traditional IRAs:

  • Contributions to traditional IRAs lower your taxable income in the contribution year. That lowers your adjusted gross income, helping you qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction.
  • Up to $10,000 can be withdrawn without the normal 10% early-withdrawal penalty to pay for qualified first-time homebuyer expenses. However, you’ll pay taxes on the distribution.

Roth IRAs:

  • Roth contributions (but not earnings) can be withdrawn penalty- and tax-free any time, even before age 59 ½.
  • five tax years after the first  contribution, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time homebuyer expenses.

 

Roth IRA

Traditional IRA

2016 Contribution Limits

$5,500; $6,500, if age 50 or older

$5,500; $6,500, if age 50 or older

2016 Phaseout of Contributions Eligibility

Single tax filers starts phasing out between $117,000 -$133,000 modified adjusted gross income.  Married couples filing jointly starts phasing out with modified AGI between $184,000 - $194,000

Anyone with earned income can contribute but tax deductibility is based on income limits and participation in employer plan.

Tax Treatment

No tax break for contributions; tax-free earnings and withdrawals in retirement

Tax deduction in contribution year; all withdrawals will be taxed as ordinary income.

Withdrawal Rules

Contributions can be withdrawn at any time, tax-free and penalty free. After five years and age 59 ½, all withdrawals are tax-free, too. No withdrawals required during account holder’s lifetime; beneficiaries can stretch distributions over many years

Withdrawals are tax-free and penalty free beginning at age 59 ½. Distributions  must begin at age 70 1/2 ; beneficiaries can stretch distributions out over many years. All distributions will be taxed as ordinary income.

Extra Benefits

After five years, up to $10,000  of earnings can be withdrawn penalty-free to cover first-time homebuyer expenses.

Contributions lower taxpayer’s AGI, potentially  qualifying them for other tax incentives; up to $10,000 penalty-free withdrawals to cover first-time homebuyer expenses, but taxes due on distributions.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This information is general in nature and should not be construed as tax or legal advice.  Please consult your tax and/or legal adviser for guidance on your particular situation.