Welcome to the Land of Confusion
One of the most confusing subjects for most investors to understand is the difference between Traditional IRA’s and Roth IRA’s and which is most suitable.
Both are IRAs, but each is very different. The bottom line is Traditional IRAs offers a possible tax deduction and are taxable when the money is withdrawn, Roth IRAs never provide a tax deduction but grow tax-free and the withdrawals are tax free. With both types the annual contribution limits are the same; $5500 per year for 2015, and an extra $1000 if you are age 50 or older.
The money inside of a Traditional IRA grows tax-deferred which means the money is taxable when it’s withdrawn. Traditional IRAs allow you to get a tax deduction on contributions as long as you don’t earn too much income. Distributions from traditional IRAs are taxed as ordinary income. If taken before 59½, you may have to pay an additional 10% early withdrawal penalty. Later when you reach age 70 ½ you must start taking minimum distributions each year or there’s a nasty penalty of 50%.
For those of you covered by a retirement plan at work the tax deduction for a traditional IRA gets phased out between $96,000 and $116,000 for married couples filing jointly for 2014. For 2015 the phase-out range is $98,000 to $118,000. If you’re a single filer, it’s phased out between $60,000 and $70,000 for 2014 and for 2015 the range is $61,000 to $71000.
Phase-out means the gradual reduction of your tax deduction over an income range.
For example, the phase-out range for a single filer for 2014 is between 60,000 and 70,000.
- At $60,000 you can deduct 100% of the contribution
- If you land in the middle, at $65,000 then you only deduct 50%
- At the end of the range, at $70,000 you deduct zero, because the deduction is now phased-out.
- The deduction gets reduced a little each year in this range until reaching zero.
Over the Phase-out Range:
What happens if you exceed the phase-out range? If you’re over the phase-out range, you can still contribute to a traditional IRA you just don’t get the tax deduction, which in most cases would make buying the traditional IRA not that advantageous.
Distributions from Roth IRAs are tax free rather than being taxable as a traditional IRA is. And that is a good thing. But there are conditions, read on…
You make contributions to a Roth IRA using after-tax dollars, in other words you never get a tax deduction. And to qualify for a tax-free and penalty-free withdrawal of earnings, the Roth IRA must be open at least 5 years and occur after you are age 59½.
Contributions to a Roth IRA are based on your income. Here comes another phase-out; for 2014, contributions to a Roth IRA are phased out between $181,000 and $191,000 married filing joint and $114,000 to $129,000 for single filers. For 2015 it is $183,000 to $193,000 for married filing joint and for single filers it is $116,000 to $131,000. You think you’re overwhelmed? We’re expected to remember this stuff! And for the most part we do!
So to summarize, traditional IRAs are tax-deductible if you qualify as mentioned above but you must pay taxes on withdrawals, while Roth IRAs are never deductible but withdrawals are tax free if you follow the rules mentioned above.
So which one should you buy? It truly depends on your given circumstances. But as a general rule of thumb, if you’re 50 or older and in a 25% tax bracket or higher, go with the Traditional IRA and take the tax deduction if you qualify. If you can’t get the deduction, go with the Roth IRA. More people qualify for a Roth since the ability to buy one is not phased out until your income reaches a much higher level.
If you have questions after reading this blog please feel free to give us a call at (815) 455-6453.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.