The Battle of The IRA's

Whether you should put some of your retirement savings into a traditional Individual Retirement Account (IRA), or a Roth Individual Retirement Account (Roth IRA), could be considered the Eighth Wonder of the World. The rules, just like most aspects of the investment world, are very confusing. However, they are the simplest of all the retirement accounts available to employees and self employed individuals.

First of all, you must have an earned income from some sort of employment in order to be eligible to contribute any money to either of these IRA’s. Passive income, such as rental income or dividend income, does not qualify. Second, you must earn at least as much as you are contributing up to the limits allowed by the IRS. Those limits for 2008 are $5,000 for individuals under the age of 50, and $6,000 for individuals age 50 and older. Contributions must be made by the tax filing date which is April 15th of the year following the current tax year.

You can make new contributions to a traditional IRA up to the year prior to turning age 70 ½ , (due to the fact that you must start taking mandatory withdrawals at that age), with no income limitations. There is no age limitation to contribute to a Roth IRA as long as you have qualified earnings, but there is an income limitation. Your adjusted gross income must not exceed $116,000 if you are single and $169,000 if you are married filing jointly. There are no mandatory withdrawal requirements for a Roth IRA.

In some cases, a traditional IRA may be tax-deductible on your current tax return. This deductibility is subject to certain income limitations, and whether or not the employee is already a participant in another employer-sponsored retirement plan. Contributions made to a Roth IRA are made with after-tax money and is not tax-deductible.

Taking money out of a traditional IRA is taxed differently than taking money out of a Roth IRA. Distributions from a traditional IRA after age 59 ½, that were previously tax-deductible, are taxed as ordinary income to the IRA owner at their current tax rate, or in the event of death, their beneficiaries tax rate. Distributions from a Roth IRA after age 59 ½ that has been held for at least 5 years, are tax-free to the IRA owner, as well as his/her beneficiaries.

Here is where the battle begins. This involves the difference between the value of taking a deduction now on your current tax return, or being able to take tax-free distributions when you retire. Since there are a lot of variables in making that decision, such as the number of years of contributions, the growth rate of the underlying investment, the size of the contributor’s estate, and whether or not you believe you will be in a lower or higher tax bracket at retirement, the answer would be different for different situations. However, my general opinion is that a current tax year deduction of $5-6,000 to a person in a 28% tax bracket may save them approximately $1,400-$1,680 on their current tax return. I consider this a temporary “fix” however. It is temporary because you will eventually have to pay taxes on the amount you deducted over the years, as well as the earnings, when you start to take withdrawals. If you need to take a large withdrawal in any given year, you may push yourself into a higher tax bracket.

Paying taxes as the money is earned, and then contributing to a Roth IRA that grows tax-free, may be more valuable in the long run, especially if you have many years of contributions compounding for a long period of time. For example, 20 years of $6,000 contributions earning a fixed 8% return compounded annually, could grow to over $296,000 (double that if two spouses are contributing $6,000 each) that can be withdrawn with no income tax liability what-so-ever. This is especially valuable if the IRA owner has a large estate and would like to pass part of it to his/her children income tax free. I call this creative estate planning as an estate worth over $2 million dollars today may be subject to federal estate taxes as well as income taxes.

Since I have only touched on some of the different variables used to determine which type of IRA might be best, I highly recommend you seek the advice of your tax preparer and a competent financial advisor who should bring together all the other considerations that must be examined in your own battle of the traditional IRA vs. the Roth IRA.