Which is better, the Roth IRA or traditional IRA? The answer is: it depends. But first, a brief look at the similarities and differences between the two.
Both types of accounts allow you to ignore the current year tax consequences of dividend and interest income. Both accounts also are exempt from the usual taxation of capital gains. This is especially important in 2013 and beyond, under current law, because the deal to avoid the fiscal cliff substantially increases taxes on dividends and capital gains. With Roth and Traditional IRA accounts, you don’t need to worry about this.
Both accounts also have a penalty feature designed to discourage early withdrawals. Unless certain conditions apply, the IRS will assess an early distribution penalty of 10 percent on any withdrawals, or distributions, you make prior to turning age 59.
The only ways to avoid the penalty are to make withdrawals for a number of specific ‘hardship’ reasons, or commit to gradually emptying the account in a series of substantially equal periodic payments, under Section 72(t) of the Internal Revenue Code.
The real difference between the two types of accounts lies in the way they are taxed when you make contributions, and later, in retirement, when you make distributions:
Traditional IRAs allow you to take a tax deduction up front - provided you qualify under the IRS’s stringent income eligibility rules. In return for this tax deduction, though, you must declare as ordinary income once you begin taking distributions.
Further, you cannot let your contributions compound indefinitely without paying tax. The IRS has strict rules for traditional IRA distributions. You must begin drawing down your traditional IRA account - and paying income taxes - by April 1 of the year after the year in which you turn age 70 1/2, under required minimum distribution (RMD) rules.
Miss an RMD payment, and the IRS penalizes you 50 percent of the amount you were supposed to take out, but didn’t.
Exceptions to RMD rules
The only exceptions are if you are still working, still participating in your current employer retirement plan and you don’t own more than 5 percent of the company. Should you have IRAs not associated with your current employer, you will be required to take RMD from those plans.
Roth IRAs, on the other hand, have somewhat the reverse tax treatment. There’s no up- front deduction, but as long as you keep the money in the account until you reach retirement age, you don’t have to worry about taxes ever again. Distributions after age 59 are tax-free. There are also no RMD rules to worry about. The 10 percent penalty on early withdrawals still applies, but only on earnings. You get the basis back tax- free, as long as you have kept it in the Roth account for at least five years.
Note: Good news - you can now contribute more to your IRA or Roth IRA. As of tax year 2013, Congress now allows you to make up to $5,500 in IRA or Roth IRA contributions per year. That is up from $5,000 in 2012. For more details, including a full description of the income limits and contribution caps, as well as hardship withdrawal provisions and rules for inherited IRAs, see IRS Publication 590 - Individual Retirement Arrangements.
Which is better?
• The Roth IRA may be the better choice if the following conditions apply:
You believe your income tax rate when you retire will be higher than your income tax rate now.
Your income in the current year is unusually low.
You don’t think you will need to use the money during your lifetime. The taxation on inheriting a Roth IRA is more generous than the taxation of inherited traditional IRAs - especially if your spouse is the sole beneficiary. Your estate may be subject to the estate tax when you pass on.
You don’t qualify to make tax-deductible contributions to a traditional IRA because your income is too high.
You also contribute to a 401(k) plan or other tax- deferred retirement plan, and the Roth IRA allows you to hedge your bets against future income tax increases.
Combining a Roth IRA with a tax-deferred retirement account is potentially a useful tax-diversification strategy.
You are relatively young, with many years of tax-free compounding ahead before you will need to take withdrawals.
You have other funds to tap before you begin drawing down your Roth IRA.
You have a judgment against you and wish to delay taking distributions in order to shelter income from creditors.
• However, the traditional IRA may be a better option for you if the following circumstances apply:
You are in a higher tax bracket than normal this year.
You qualify for the tax deduction under the IRS’s income rules.
You distrust Congress, and believe they may start taxing Roth IRA withdrawals in the future, despite the current tax law.
You expect your tax rates in your retirement years to be lower than your tax rates in the current year.
You are relatively close to retirement.
You expect to need to use the money, so taking out an RMD is no hardship, since you’d be taking it out anyway.
One thing most financial experts agree on - whether you use a Roth IRA, traditional IRA, an employer plan, a taxable account, annuities or cash value life insurance – is that it’s vital to take responsibility for your own retirement security. The most important thing is to contribute early and contribute often. Taxes play an important role in determining your financial future.
If you are considering this option, it would be wise to have a complete analysis to assist you determine whether or not a Roth IRA conversion makes sense for your particular situation. You may obtain an objective analysis tailored to your circumstances by engaging an independent tax and preparation firm consisting of CPAs and tax professionals. Some firms offer this service with charge. My firm provides this complimentary service to our clients and friends without charge. Should you have an interest in a customized analysis, please do not hesitate to contact our office.
Bob Adams is president of A SafeHarbor, a firm specializing in assisting families in having a calm retirement when faced with stormy financial waters. Visit aSafeHarbor.com or call 407-644-6646 for more information.