Roth IRAs or Traditional IRAs
Roth IRAs OR TRADITIONAL IRAs?
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Both Traditional Individual Retirement Accounts (Traditional IRAs) and Roth IRAs allow taxpayers to save for retirement and reap tax benefits along the way. A check with a short application to a brokerage firm, a mutual fund company, or a bank is usually all it takes to set up one of these accounts.
These two types of IRAs offer tax advantages at different times. The rules governing Traditional IRAs allow a taxpayer to deduct his contributions upfront on his tax return in the year he puts money into the account, presumably when he is in a higher tax bracket, but require that he pay income tax when he later withdraws the money upon retirement, presumably at that time he would be in a lower tax bracket. A beneficiary who receives distributions from a decedent’s Traditional IRA usually also must pay income tax on the amounts received.
Using a Roth IRA, on the other hand, generates no upfront tax deduction to the taxpayer when he contributes to the account but the withdrawals, either made by herself or her beneficiaries, are usually free from income tax. Roth IRAs are particularly attractive to younger taxpayers whose retirement accounts may appreciate substantially by the time they are ready to make withdrawals.
Every year, taxpayers have until April 15th to contribute to their Traditional and Roth IRAs and have the contribution count toward the previous year. Contributions made at the beginning of the year should be clearly designated either for the current year or the previous year, and contributions made to a Traditional IRA designated for a previous year will reduce the prior year’s tax liability.
How much can I contribute to my IRAs?
For 2005, the maximum amount a person could contribute to a Traditional IRA was $4,000. In 2006 the limit stays at $4,000 and will remain there for 2007 as well. The limit will increase to $5,000 in 2008. For taxpayers who are 50 or older, the combined total contributions are higher. For 2005, the maximum contribution for someone age 50 or older was $4,500; that number has increased to $5,000 for 2006 and 2007. In 2008, the limit on the combined total contributions for taxpayers who are 50 or older at that time will be $6,000. These limits are the total amounts that can be contributed to all the Traditional IRAs owned by the taxpayer. They can not be circumvented by the ownership of multiple Traditional IRAs.
How much a taxpayer may contribute to his Roth IRA for the year generally depends on the amount of his contribution to a Traditional IRA that year. If a person owns only a Roth IRA and no Traditional IRAs, the contribution limit is the contribution limit for a Traditional IRA or the taxpayer’s taxable compensation, whichever is smaller.
There are other restrictions to how much a taxpayer may contribute to his IRAs. For example, a taxpayer must have enough earned income to cover his contributions and, therefore, someone who has no earned income for the year may not make any contribution to his Traditional IRA or a Roth IRA that year. However, stay-at-home spouses who have no earned income may make contributions to IRAs under special rules that apply only to them. A taxpayer’s contribution may also be limited by the income tests discussed immediately below.
Is everyone eligible to participate in a Traditional IRA or Roth IRA?
Certain high-income individuals either may not be allowed to deduct contributions made to Traditional IRAs or may find the amount they are allowed to deduct somewhat limited.
For example, a taxpayer who participates in his company’s qualified pensions plan and has annual income over a specific amount may not deduct contributions to his Traditional IRA. That income amount in 2006 is $85,000 for married taxpayers filing joint returns, and $60,000 for single taxpayers. Furthermore, a taxpayer who makes $160,000 or more a year may not deduct contributions to a Traditional IRA if his spouse participates in a company retirement plan, even if he himself does not participate.
In addition, there are limits on a taxpayer’s ability to contribute to Roth IRAs. For example, married taxpayers filing joint returns with annual income of at least $160,000 and single taxpayers with at least $110,000 in annual income are not allowed to contribute to a Roth IRA. On the other hand, unlike Traditional IRAs, a taxpayer’s participation in a pension plan has no effect on her ability to contribute to a Roth IRA. This is why taxpayers who participate in their company’s qualified pensions plan often use Roth IRAs either alone or in conjunction with Traditional IRAs to invest up to the maximum for the year.
Finally, most married taxpayers who file separate returns are ineligible to contribute to either a Traditional or Roth IRA for that year.
Once I put money in a Traditional IRA or a Roth IRA, when can I take it out, and what if I need it for emergencies?
Because IRAs are meant for retirement, a taxpayer who withdraws funds from either her Traditional IRA or Roth IRA before she turns 59½ will incur a ten percent penalty tax assessed on the withdrawn amount. Note that this is in addition to any income tax owed on the amount withdrawn. The IRS usually forgives the penalty when the money is withdrawn for one of a limited number of purposes that include, for example, the taxpayer’s disability, or the purchase of a first home for either the taxpayer or a close family member such as a child, a stepchild, or a grandchild.
After a taxpayer turns 70½ he must start withdrawing from his Traditional IRA. This is because the Traditional IRA is a retirement planning vehicle and not a means to indefinitely accumulate assets income-tax free. With respect to Roth IRAs, there is no requirement that taxpayers withdraw funds since withdrawals would not be subject to income tax anyway.
Care should be taken when IRAs are to be inherited by a child or spouse because, with proper planning, payments may be deferred thereby postponing the income tax burden to the recipient. Finally, although IRAs can be used for sheltering income tax while the taxpayer is alive, at the taxpayer’s death they trigger estate tax considerations that should be addressed in estate planning.
©Elina Yi-Lin Hum, Attorney At Law,
