The United States Congress and the Internal Revenue Service want to help you save money, accumulate wealth, and retire. What? Before you claim that I fell off my rocker, read on.
Like many congressionally inspired programs, the Individual Retirement Account (IRA) was fairly simple and straightforward in its initial conception. As congress tweaked and enhanced these tax-favored vehicles, the initial simple concept of the IRA has developed into quite a complex web of rules across a host of different types of IRAs. This article will focus on one of the most common IRA related questions, “Should I have a Traditional or Roth IRA?”
Let’s first look at some of the key components of these IRAs.
Contributions that an individual makes to a Traditional IRA are tax deductible if neither the taxpayer nor the taxpayer’s spouse is covered by a qualified plan (i.e. 401k or pension). If either the taxpayer or taxpayer’s spouse is covered by a qualified plan, contributions to an IRA may still be deductible, depending on how much money they make. Tax deductibility is a key advantage.
In addition to receiving a tax deduction, another benefit of funding a Traditional IRA is that the assets are able to grow on a tax deferred basis. In other words, the IRA owner is not taxed each year on the earnings and growth of the IRA. This is a powerful benefit that increases over time as the miracle of compound growth takes hold.
There is an important distinction to make between tax-deferred and tax-free. While the earnings in a Traditional IRA are tax-deferred and therefore not taxed each year, these earnings that accumulate over time are not tax-free. When you redeem the funds from the IRA during retirement, the IRS will treat the withdrawals as taxable income and you will owe income tax.
There are two important ages to remember when you own a Traditional IRA. If you take a distribution from your IRA prior to age 591/2 you will most likely owe income tax and an additional 10% penalty. The government doesn’t want you to play keep-away with your tax dollars indefinitely, however. Once you reach the age of 701/2 the IRS will require that you begin to take distributions from your Traditional IRA.
Now let’s take a look at the Traditional IRA’s younger cousin, the Roth IRA.
This powerful retirement savings vehicle became available during the 1998 tax year. While Roth IRAs share some of the same characteristics as Traditional IRAs, such as annual contribution limits, the age 591/2 rule and the ability to compound each year without being taxed, they have several major differences as well.
Taxpayers contributing to a Roth IRA do not receive a tax deduction. After-tax dollars are contributed to Roths. The powerful benefit of a Roth IRA, however, is that when you retire and take distributions, they will exit the Roth IRA tax-free. The earnings inside of a Roth will not be taxed if you withdrawal the assets after reaching age 591/2 and you’ve had a Roth for at least five years. Tax-free withdrawals are the major benefit of Roth IRAs and are the reason they have exploded in popularity over the past decade.
Another difference between Roth IRAs and Traditional IRAs is that Roth IRA owners do not need to begin taxing distributions at age 701/2. The dollars are coming out tax-free so Uncle Sam has no incentive to force you to deplete the funds in the Roth.
Traditional IRA owners that meet certain eligibility requirements may convert their Traditional IRAs to Roth IRAs. This conversion is a taxable event, but the earnings in the new Roth IRA moving forward will have the ability to remain in the IRA setting for a longer time (no age 701/2 rule) and if the dollars are redeemed after you reach the age of 591/2 , you can tell the IRS to stay away (tax-free withdrawals).
Investors that may want to consider a Roth IRA would include:
- Younger workers (although Roths can be in the best interest of the “more experienced” taxpayer, as well). The younger you are, the more time you have for the assets to grow on a tax-free compound basis. The greater the compound growth, the greater the tax-free withdrawal.
- Anyone who suspects that we will vote politicians into office that will increase income tax rates in the future.
- Anyone who wants to shelter income and earnings from taxation after he or she reaches age 701/2.
There are many rules that govern IRAs that have not been discussed in this article. Due to the complex nature of the tax code that governs IRAs, it is recommended that you speak to a professional advisor prior to opening, closing, or modifying such accounts.
Let me conclude this article the same way I close most of my discussions regarding retirement planning. The most important advice I can give anyone who is saving for retirement is simply to save as much as you can as early as you can. In the world of compound growth, time is your best friend.
The views in this article do not necessarily reflect those of the Debt Consolidation Loan Directory.
This article is for educational purposes only and is not a personal recommendation of any strategy or product. You should not make any changes to your financial situation based only on this article. It is advised that you consult a qualified advisor and tax professional to evaluate your situation before making any changes to your finances.