Should I Contribute to My Roth IRA or Traditional IRA?

Should I Contribute to My Roth IRA or Traditional IRA?

A Roth IRA is funded with after-tax money, but grows tax-free and qualified distributions are also tax-free.  A Traditional IRA is funded with pre-tax money and grows tax-deferred. Qualified distributions from a Traditional IRA are taxed as regular income.

In short, with a Roth IRA you pay the tax on your earned income first.  With a Traditional IRA you pay the tax last, after growth from dividends or capital appreciation, on a possibly much larger amount later.  Distributions from a Traditional IRA are subject to income tax conceivably at a lower level since your earned income will presumably be lower in retirement. Traditional IRA distributions are not eligible for preferential, and possibly lower, long-term capital gains rates. 

Given the right circumstances, both are excellent ways to help fund retirement and combining both may make sense as a way to diversify against the risk of future tax policies.

For instance, if the immediate tax savings of the Traditional IRA means that you will be able to put more away, than a Traditional IRA can be the better way to go.

If you don't want to have to take minimum required distributions, or you don't want to pay taxes again, then a Roth IRA can be the better choice.

In fact, since Roth IRAs do not require minimum distributions, they are a great vehicle to build wealth to pass on to future generations if you yourself do not expect to need the income from the investment.  In a strategy dubbed a "Stretch IRA" you can pass on the entire value of the retirement account to a beneficiary in a succeeding generation who will also enjoy income-tax free compounding for an extended period of time.  Other tax considerations may apply, such as Generation Skipping Taxes, or limitations on owners of more than 5% of a business so please consider consulting with a tax specialist.

Generally, if you will be making the maximum contribution to either type of IRA, the longer you have until retirement, the more beneficial the Roth IRA type. Closer to retirement, the Traditional IRA has advantages.

But in both cases there are still a number of variables that can tip the scale either way. For instance, if you are close to retirement but won't be drawing from the IRA for years, if at all, then a Roth IRA can be the better way to go.

To ensure a well-funded retirement for a decent quality of life, DO SOMETHING.  Don't let the complexity of these issues deter you from action.  You can fund one or the other or even a combination of both.  Just remember that the maximum combined contribution is still the same as if you were just funding one.

As with any IRA, you have until April 15 of the following year to make a current tax year contribution:  April 15, 2009 for your Y2008 contributions. The 2008 maximum contribution amount for both the Roth and Traditional IRAs is $5,000 (increased to $6,000 if you will be age 50 or older at year-end) or the total of earned income, whichever is less.

In order to contribute to either IRA, you must have earned income from wages, self-employment or taxable alimnoy, for example, of at least the amount of the intended contribution.

For married couples filing jointly, either spouse can meet the required earned income test.

There are a number of income phase-outs based on your adjusted gross income (AGI) affecting the eligibility to make either type of IRA contribution. 

Another factor impacting IRA eligibility is your eligibility to participate in a company or non-profit retirement plan - you only have to be eligible.  If you are eligible that will restrict your IRA options outside your company plan.  Whether you participate in your company's plan is irrelevant.

Before funding an individual IRA be sure to explore the benefits available to you from your employer in order to properly coordinate with any IRA contributions.

Many companies and non-profits offer matching contributions - a "bonus" to your earnings, in effect - and most plans have contribution limits higher than individual IRAs - example: up to $15,000 in deferrals for 401ks.

Even if you do not qualify to make a Roth IRA contribution or a tax-deductible contribution to a Traditional IRA, you may still qualify to make a non-deductible Traditional IRA contribution.  While it may not lower your current year's income taxes, there is great value having your contribution earn income and grow without having to pay taxes on earnings until you do retire or take a distribution.

Tax advantaged retirement accounts are a great way to save for retirement.  So whatever you do, don't let the complexity of the choices result in inaction.  Procrastination is dangerous to your future financial health.

Consult with a competent tax professional and financial advisor to help sort out your choices.

Steve Stanganelli, MSF




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