The Traditional Individual Retirement Account (IRA) and the Roth IRA offer ways to save for retirement, although each offers different benefits and advantages. This article explores the important decision variables when choosing between the two, as well as the impact of each on your current vs. future tax liabilities.
The Traditional IRA allows an individual with earned income to take a tax deduction for dollars contributed (if income falls below a certain threshold), and the growth in the account is tax deferred. When distributions are taken from an IRA, they are taxed as ordinary income. If one chooses not to take distributions from an IRA after reaching 59 ½, the IRS will force distributions to be taken at age 70 ½. These are known as required minimum distributions (RMDs) or sometimes minimum required distributions (MRDs) and are based on the presumable retiree’s life expectancy.
In order to take the deduction in 2012, an employee who is covered by an employer-sponsored retirement plan (a 401k or equivalent plan) must make less than $58,000 to $68,000 ($59,000 to $69,000 for 2013) as an individual or $92,000 to $112,000 ($95,000 to $115,000 for 2013) as a married couple. If one of two spouses is covered by an employer-sponsored plan, the income limits for the household are increased to $173,000 to $183,000 ($178,000 to $188,000 for 2013), and if no one in a household is covered by a plan, there is no income limitation in order to deduct contributions to a Traditional IRA.
For the ranges specified above, Traditional IRA contributions are subject to an income phase-out rule, meaning that if your income falls within these ranges, your ability to take a tax deduction is phased out. So, for instance, as an individual in 2012, if you make less than $58,000, you will receive a full deduction; if you make between $58,000 and $68,000, you will receive a phased out deduction; and if you make more than $68,000, you will receive no deduction.
The 2012 contribution limit for a Traditional IRA is $5,000 with an extra $1,000 catch-up contribution for those 50 and over. The 2013 contribution limit is $5,500 with, again, an extra $1,000 catch-up contribution for those 50 and over.
The other option is a Roth IRA. The Roth IRA was established as an account into which after-tax dollars are invested. While the Roth gives no tax deduction on the front end, the growth – and eventual distribution – is federal tax-free. The Roth IRA allows one to take out 100 percent of contributions at any time for any reason with no taxes or penalties. It is only the growth on which one must wait until the age of 59 ½ to draw penalty free. There is also a five-year aging period, which means that a payment made from a Roth IRA account is considered a qualified distribution if it made after a five-year period, beginning with the first taxable year after which a contribution to the Roth IRA occurs. There are exceptions for death or disability, and there is a one-time $10,000 qualified distribution for first time home buyers.
As of 2012, if you make less than $110,000 for a single individual or $173,000 for a married couple, you can contribute $5,000 per person ($6,000 for individuals age 50 or older). In 2013, this changes to $112,000 for a single individual and $178,000 for a married couple, and the contribution cap increases to $5,500 per person ($6,500 for individuals age 50 or older).
For 2012, between $110,000 and $125,000 for an individual or $173,000 and $183,000 for a married couple, your allowable Roth contribution is phased out, and if you make over those top thresholds, you’re not able to contribute to a Roth IRA. In 2013, the amounts change to between $112,000 and $127,000 for an individual and $178,000 and $188,000 for a married couple.
So now the stage is set for the epic battle: Traditional IRA versus Roth IRA. The contrast is argued by many sides for various reasons. Most have focused on the difference between the two regarding taxation. It is commonly suggested for folks who would anticipate a higher rate of tax in the future, the Roth is the best option. For those, however, currently in their peak income earning years and expecting a lower tax rate in retirement, the Traditional IRA has always been considered best.
One decision variable to keep in mind too, however, is income tax levels in the future. Most of the income generated by those in retirement is taxable. Even though at its inception Social Security income was promised not to be taxed, now up to 85 percent of one’s Social Security retirement benefit is taxed. Pension income is taxed, although some states do not tax recipients of some pension income to draw retirees to their state. And, of course, tax-deductible contributions to 401ks and IRAs are going to be taxed in the year in which you take a distribution.
There are pros and cons to each retirement account, but ultimately the decision should be based on your own situation with special attention paid to your age and where you are in your career (peak income years versus retirement years).