This is by far the most asked question I see in every discussion of IRAs. You want to open an IRA, but don’t know which plan to use. All the different rules just frustrate you to no end. There are advantages and disadvantages with both a Roth IRA and a Traditional IRA. If you have a good handle on your present financial picture, and realistic projection of your future salary increases, the answer gets easier.
So let’s look at each of the characteristics for Roth and Traditional IRAs…
IRA Contribution Amount Limits
Contribution limits for the Roth and the Traditional are the same. For 2011, you can contribute up to $5,000, plus an additional $1,000 if you are age 50 or older.
IRA Contribution Age Limits
Your ability to contribute to a Traditional, and deduct contributions, ends at age 70 ½. For Roth IRA’s, there are no Age Limitations. This point may affect highly paid people who continue to work into their 70’s, but it’s no big deal for 98% of the public.
IRA Contribution Tax Deductions and Income Limitations
This is the point everyone focuses on when deciding on a Roth vs. Traditional. Do you take the tax deduction now for the contribution and get taxed later (Traditional IRA)? Or eat the tax now and enjoy tax free withdrawals later on (Roth IRA)?
I have seen some people really suffer over this question. Many accountants I’ve talked to advise going with a Traditional IRA. That’s logical, and expected, since their job is to have you get the largest tax refund each year. But this can be shortsighted. Being able to take tax free withdrawals under a Roth is a very big advantage in retirement.
Roth IRA Limits
IRS limitations can drive you crazy. Here are the Roth limits which determine if you can contribute to a Roth IRA in 2011:
2011 Roth IRA Income Limits – 2011
|Filing Status||Full Contribution||Reduced Contribution|
|Single /Head of Household||Up to $107,000||$107,001 to $122,000|
|Married Filing Jointly||Up to $169,000||$169,001 to $179,000|
So, if you are Single and earn over $122,000, or Married and earn over $179,000, you can’t contribute to a Roth in 2011.
Then, look at the Traditional rules to see if you can make a deductible contribution.
Traditional IRA Income Limits – 2011
In Traditional IRA’s, if you are not covered by a pension or 401k plan, you generally don’t have any income limitations. As discussed previously, if you ARE covered under a Pension or 401k plan, the amount of your tax deduction is subject to the following limits:
|Filing Status||Full Tax Deduction||Reduced Tax Deduction|
|Single / Head of Household||Under $56,000||$56,000 - 66,000|
|Married Filing Jointly (Both Have Pension)||Under $90,000||$90,000 - 110,000|
|Married Filing Jointly (One Has Pension)||Under $169,000||$169,000 - 179,000|
So, if you are Single and earn over $66,000, or Married and earn over $179,000, you could contribute to a Traditional IRA, but you can’t take a tax deduction. Kind of useless.
Roth vs Traditional IRA Comparison
Workers with income in the middle of the ranges really have to do some thinking and calculating. For Single Workers, the income level is pretty easy to spot and decide.
- If you earn under $56,000 and covered under a 401k, you are eligible for both Roth and Traditional. You just need to decide if you want a tax deduction now or tax free at retirement.
- If you earn over $66,000 you can only use a Roth IRA.
- If you earn $56,000-$66,000, you are eligible for a Roth and a partial tax deduction under a Traditional. Here you need think a bit. Should you bother doing a Traditional if you only get a minor tax deduction? And if you do Traditional, you will probably have another administrative fee.
- The biggest question – at your income level, can you afford to make a contribution into either program without really strapping yourself?
For Married Workers, you can see the decision is more complex. Are you, your spouse, or both covered under a pension or 401k? How much tax deduction do we get under each scenario? You can sit and calculate this for hours. I’ve done it. We’ll try to make the decision easier under the Decision section below.
Read What is a Traditional IRA and Who is Eligible for a Traditional IRA for more detailed information on eligibility and tax deduction rules.
Required Minimum Distributions
Roth IRA owners have no restrictions on withdrawals as long as you are over age 59 ½ and it has been at least 5 years since you opened your first Roth. If you meet these two rules, take as much out whenever you want.
For Traditional IRA owners, you have to start taking money out at 70 ½, even if you don’t want to. Wealthy people try to delay withdrawals since they don’t need the income and withdrawals would just add to their tax bill. But for 90% of the public, being forced to take a distribution at 70 ½ is no big deal.
Tax Treatment of IRA Withdrawals
Under both Traditional and Roth’s, earnings withdrawals before age 59 ½ get taxed as ordinary income and may incur a 10% penalty. But under a Traditional IRA, your own contributions are also taxed when withdrawn since you received a break on taxes when the contributions went into the plan.
In a Roth, earnings withdrawals are tax free if you are over 59 ½ and been in a Roth for more than 5 years.
In a Traditional, all your earnings distributions are considered Ordinary Income for tax purposes both over and under age 59 1/2.
The main theme to think about is your tax bracket now vs. what it will be in retirement. Are you young, not earning much, but expect your career to grow? You’re in low bracket, say 15%, but expect to be in a much higher bracket, say 35% later on.
Then you need to picture your retirement years. Will your tax bracket drop because you are no longer working? Or do you plan to never really retire, but just change careers into some type of money making hobby?
These considerations all come into the decision of whether to open a Roth or a Traditional IRA.
Deciding Which Plan is Better
By now, you’re probably so sick of the calculations and requirements that you want to forget about the whole subject and just go take a nap.
Well, let’s simplify the decision:
1. Are you covered by a Pension, 401k, or other plan at work?
If you are covered, you are already amassing the major portion of your retirement savings on a tax deferred basis. Meaning — all or much of the income or withdrawals you receive from these plans will be taxable to you when you retire. This will keep your tax bracket higher in your retirement years.
Do you really need more taxable income on top of that by taking a Traditional IRA withdrawal? Believe me, when you are at retired and see your tax bill, you will wish you had some tax free money to get your hands on.
Many Accountants and Financial Planners say you should base the decision on whether you will be in a lower tax bracket at retirement. Your bracket should be lower because your salary stops and therefore they suggest you go with a Traditional IRA.
But the real question is whether you will spend less in retirement. If yes, you will pull out less from your tax deferred accounts and, therefore, your tax bracket will drop. But if you are like most people, you manage to spend the same as you do before retirement, at least for a number of years. This will cause you to pull out an amount equaling your salary from the tax deferred accounts. Since this is all taxable money, your tax bracket will be roughly the same as before you retired. So, going with a Traditional on the assumption your tax bracket will drop is not totally realistic.
More importantly is the effect of a tax deduction now vs. later. Under a Traditional, if you contribute $200 per month ($2,400 total) into a Traditional this year, and you’re in the 15% tax bracket, your tax refund will be bigger by $360 (.15 X $2,400). If this $200 per month earns 4% interest, then in 25 years this will grow to $ 103,313.57. If you withdraw the money at that time, you will be paying taxes on investment earnings of $43,000, with the rest being your own contributions that you put in.
If you had contributed the same amount to a Roth, you would lose the $360 in tax savings this year. In 25 years, you can take out the $103,313.57 totally tax free.
I would really consider going with the Roth. I understand you are giving up a tax deduction now, but you’ll be glad later on. View it as putting money into your saving account, but not having to pay taxes when you take it out.
If you really, truly don’t want to lose the tax deduction now, then think about splitting your contribution between a Roth and Traditional to get the benefits of both. You may pay an additional administrative fee, but this will give you piece of mind that you made the right decision.
In the end, don’t agonize over the decision. One way or another, you are saving for retirement, and that is the most important point. Keep saving and you will enjoy your retirement years.
Summary Chart of Roth IRA and Traditional IRA
The following chart summarizes the similarities and differences between the Roth and traditional IRAs:
|Roth IRA||Traditional IRA|
|Contribution Limit||$5,000 plus a catch-up contribution for those at least 50 years old||$5,000 plus a catch-up contribution for those at least 50 years|
|Deductibility||Contributions are never deductible||Contributions might be deductible, subject to tax-filing and active participant statuses, as well as income amount|
|Age Limitation||No age limitations||No contributions after age 70.5|
|Tax Credit||Available for 'Saver's Tax Credit'||Available for 'Saver's Tax Credit'|
|Income level for Contributions||Income levels may prevent taxpayers from contributing||Can contribute, but income levels will prevent taxpayers from tax deduction|
|Treatment of Earnings on Investments||Withdrawals after age 59 ½ are tax free. Earnings grow on a tax-deferred basis||Earnings are taxed upon distribution|
|Distributions Rules||Distributions may be taken at anytime. Distributions are tax free after 59 1/2 Distributions may be taken at any time.||Distributions will be treated as ordinary income and may be subjected to an early- withdrawal penalty if taken out while under age of 59 1/2.|
|Required Minimum Distribution||No minimum withdrawal rules||Withdrawals must start at age 70 1/2|