Roth or Traditional IRA?

Most people are confused on the differences between Traditional and Roth IRA’s and which one is right for them. I will help to clear the proverbial haze. First lets define what an IRA is.

IRA?

An IRA is short for Individual Retirement Account. They are designed to help people save for retirement.

Traditional VS. Roth…

A traditional IRA is one in which the participant makes contribution from his/her income BEFORE taxes are taken out. In 2007 one can make a maximum contribution of 4000 dollars. If you are over 50, then you can make a 500-dollar “catch-up” contribution. However the US Government will only allow one to contribute a total of 15,500 of pre-tax dollars (depending on income). This means that if you are maxing out your 401K contribution (pre-tax) then you CANNOT contribute to your IRA using pre-tax dollars.
A Roth IRA is an account in which a participant makes contributions from income that has already been taxed. The Contribution limit of $4000 is still imposed on Roth IRA’s as well.

When would someone choose a traditional IRA?

Most financial planners would recommend someone who would receive tax benefits from reducing their income to contribute via a traditional IRA. It may be easier to understand the concept by knowing when NOT to contribute to a traditional IRA account. One would NOT want to contribute to a traditional IRA if they will not see a significant increase in the dollar amount of their tax return. Also, if the person is nearing retirement, they should not contribute to a traditional IRA. The logic in contributing to a traditional IRA account is that the person will see more growth because the money was contributed pre-tax. I.E. the money has a longer time to grow and multiply so one would want to contribute as much as possible. When that person starts taking disbursements they will most likely be in a lower tax bracket and therefore will see a tax savings.

When would someone want to choose a Roth IRA?

Roth IRA’s are the correct choice for someone who wants a tax free retirement. The money in the IRA accounts will have already been taxed so the government won’t do it a second time. Someone nearing retirement would want to contribute to an IRA. The other positive aspect of a Roth IRA is that person does not have to start taking distributions from the account when that person has reached 70 and 1/2 years old like they do with the traditional.

What are the Phase-Out Limitations?

Depending on the level of income reported on the person’s tax return, there are reductions to the amount they can contribute.

Single
For those who file as single, they see reductions in the level of contributions starting at $95,000/year and are no longer able to contribute any amount at $110,000.

Married Filing Jointly
Married person’s filing jointly will have a reduced contribution limit for each persons IRA if their adjusted gross income exceeds $150,000. If their adjusted gross income reaches $160,000, each persons contribution limit is zero.

Married Filing Separately and Living Apart
If you are married but file separately and have lived apart from your spouse for the entire tax year, your IRA contribution amount will be reduced if your adjusted gross income is more than $95,000. You Roth IRA contribution limit will be eliminated if your adjusted gross income reaches $110,000.

Married Filing Separately and Living Together
If you are married filing separately and lived with your spouse at any time during the tax year, your Roth IRA contribution amount will be reduced when your adjusted gross income exceeds $0.00 and will be completely eliminated when your adjusted gross income reaches $10,000.

IRS Tax Penalties

Someone who has made any contributions in a traditional IRA account must start taking distributions from that account by the time they reach 70 and 1/2 or they will incur a 50% penalty on the amount they should have taken out. If a person were to make an excess contribution they will incur a 6% penalty. Finally, if some takes a premature distribution they will incur a 10% penalty.

How To Start

I would highly recommend everyone going to see their accountant, attorney, and or financial advisor before contributing. These individuals will provide the best advice and have a clear plan for the client.

There is more to IRA’s, I just wanted to cover the main differences between Roth and Traditional. So please e-mail me if you have ANY questions! I would be more than happy to answer them.