How to choose between a traditional IRA and a Roth IRA.
The efficiency of the driver’s license bureau. The readability of the IRS’s rules. The Postal Service’s track record of setting stamp rates (that last more than six months). Let’s admit it, the government won’t exactly win any awards for innovation or organizational effectiveness.
But on a few occasions, the suits down at Capitol Hill get it right. Two examples are the are the Tax Reform Act of 1986 and the Taxpayer Relief Act of 1997. The first of these created the individual retirement account (IRA) and the later piece of legislation created the Roth IRA.
For the casual investor, saving for retirement can seem complicated and intimidating. Which plan should I choose? A Roth IRA or a traditional IRA? Do I go with an employer 401(k) or do it on my own? Should I invest in Costa Rican coffee bean futures?
Well, maybe you shouldn’t be asking the last question (if you are, I’ve got a lovely bridge in New York with your name on it – email me for details). And, yes, it can get complex, but a few simple guidelines can help you find the right investments for your situation.
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401(k) not an option? Meet my friend IRA.
For the self-employed or those who work for an employer with no retirement plan (and that’s a lot of us out there), IRAs are the best bet. IRAs are similar to 401(k)s in that they offer tax incentives to encourage saving for retirement. And they come in two flavors: traditional IRAs and Roth IRAs.
Here are the basics about the two types of IRAs:
- Contributions are tax-deductible (with some income restrictions).
- Anyone can contribute to a traditional IRA (although if you don’t qualify for the tax break because you earn too much, you might as well just invest in a mutual fund).
- Income tax is paid on the earnings when funds are withdrawn (same way your regular income is taxed now). Investor-speak refers to this as tax-deferred earnings.
- If you take money out before you turn 59½, you get hit with a 10 percent penalty.
- Distributions (withdrawals) are mandatory when you reach 70½ years of age.
- Contributions are not tax-deductible, but…
- Earnings on those contributions can be withdrawn tax-free. Yes, really.
- Not everyone qualifies. If your modified adjusted gross income is over $179,000 (married, filing jointly) or over $122,000 (single filer), sorry to break the news to you.
- Contributions can be withdrawn penalty-free before you hit 59½, but the earnings on those contributions get the same 10 percent penalty traditional IRAs do.
- No mandatory withdrawals at any age.
Which IRA to choose? Traditional or Roth? Both? Neither?
Answer the following question: do you think your income taxes will be higher or lower at retirement? If you’re in a 20 percent bracket now and you think you’ll be in a higher bracket at retirement (you plan to live it up in your golden years), you’re better off skipping today’s tax deduction and going with a Roth IRA. If you think your income needs at retirement will be less than today (because you’ll have the house paid off and the kids’ college bills will be behind you), then you may actually be in a lower tax bracket at retirement. In that case, a tax-deferred traditional IRA is the right choice.
[Check Your Credit: Don't Guess. Know.® Get your free credit report and score. No credit card required.What you should strive to achieve is minimizing the taxes on your investment by choosing to pay taxes now (Roth IRA) or later (traditional IRA).
I know what you’re thinking. How am I supposed to know if my income tax rate will be higher at retirement than it is now? Tax rates change all the time, and I have no idea what my income needs will be in 30 years.
OK, I don’t have a crystal ball or one of those fortune-telling bird fountains Frodo looked into with the Elf Queen. But I will go out on a limb and not give the standard financial writer’s “it depends on your situation” answer.
Unless you’re not eligible for one because of income restrictions, I’d favor Roth IRAs. Why? These two reasons tip the scales for me:
- You don’t really know what your income needs will be at retirement, but wouldn’t you rather opt for tax-free withdrawals after retirement, when you probably won’t have a regular job and every dollar will count?
- Take a look at the government’s budget deficit and the entitlement requirements (Social Security payments to retirees, Medicaid, Medicare, etc.) for the next 20 years and beyond. Not a pretty picture. That gap has to be filled somehow, and cuts alone won’t get us there. Like it or not, it’s a safe bet that taxes are going up.
My opinion aside, the reality is that any tax-incented investment account that encourages savings for retirement is a great thing, whether it’s a traditional IRA, Roth IRA, 401(k) or Cayman Islands dummy corporation (note to self: please strike that last one in the final draft).
Seriously, we’re all living longer these days, so every dollar you can save for retirement will be well worth it in the long run—and both IRAs and Roth IRAs offer a great way to get started.
Whether you’re a savvy saver or just getting started with your retirement fund, Quizzle.com has a “wealth” of financial tools to help you make the most of your money. At Quizzle, you can learn how to get out of debt faster, improve your credit score and better your entire financial situation.
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