The Roth IRA presents a potentially attractive alternative to the traditional IRA long favored by many Americans as a cornerstone in their retirement planning efforts. That's because a Roth IRA may allow you to avoid future taxation of your retirement funds by making nondeductible contributions now.
Following is a summary of the rules for Roth IRAs:
Unlike the traditional IRA, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.
Your total annual contributions to all IRAs are limited to $5,500 in 2013. Individuals who are at least 50 years old by the end of the year are also able to make so-called catch-up contributions to a Roth IRA. The allowable catch-up contribution is $1,000 per year but is not adjusted for inflation. The contribution limit begins to decline or "phase out" for single taxpayers with adjusted gross incomes (AGIs) of more than $112,000 and for married couples filing jointly with AGIs of more than $178,000. Individuals with AGIs in excess of $127,000 ($188,000 for married couples filing jointly) are not eligible for a Roth IRA. Married taxpayers filing separately are not allowed to contribute to a Roth IRA.
Contribution limits may increase in the years ahead. In the future, the annual contribution limit may be adjusted for inflation.
Your contributions to a Roth IRA may continue beyond age 70½. You are not required to start taking distributions from a Roth IRA at age 70½, as you are with a traditional IRA, and you can continue to contribute as long as you have earned income. When a Roth IRA owner dies, however, his or her heirs must adhere to the same minimum distribution rules that apply to traditional IRAs.
Qualified distributions from a Roth IRA are tax free. While your contributions to a Roth IRA are never tax deductible, your distributions may be tax free if you have owned the Roth IRA for at least five years and:
You may qualify for the "first-time home purchase" if you have not owned a home for at least two years before the date on the purchase contract or the date when construction started. You, your spouse, or a descendant or ancestor of either may qualify as the buyer.
The taxable portion of a nonqualified distribution is subject to a 10% tax penalty. If you make withdrawals that do not meet the rules for a qualified distribution, you'll owe taxes on all or a portion of the withdrawal. You must also pay a 10% penalty tax on the taxable portion of the withdrawal.
Penalty-free withdrawals are permitted for qualified education expenses. If you are under age 59½ but have held the Roth IRA for five years, you may withdraw funds penalty free to pay for qualified education expenses for yourself or family members. You will have to pay income tax on the taxable portion of the distribution, however.
Retirement plan "rollovers" are permitted. If you are changing jobs or retiring, you can roll over funds from an employer retirement plan, such as a 401(k) account, directly to a Roth IRA. In the past, you could do this only if your workplace retirement account was a Roth-style plan. But since 2008, direct rollovers from a non-Roth plan have been allowed. The rollover is treated as a conversion, with income taxes due on all proceeds.
When deciding whether a traditional IRA or a Roth IRA is best for you, you'll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals. For many people, a Roth IRA will result in more after-tax income during retirement because qualified withdrawals from a Roth IRA are tax free, while withdrawals from a traditional IRA will be taxed.
For those whose contributions to a traditional IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a traditional IRA may be the smart choice.
If you are not eligible to participate in a company-sponsored retirement plan, you can make deductible contributions to a traditional IRA regardless of your income level, up to $5,500 in 2013 (or $6,500 if you are at least 50 years old). Deductible contributions may be reduced or eliminated for individuals who participate in a company-sponsored retirement plan, based on their incomes.
The Traditional IRA
|The traditional IRA may still provide an advantage over the Roth IRA to those who maximize its benefit. Here's how: You invest the tax savings from your IRA deduction in a traditional account each year and let that account grow along with your IRA. Assuming your tax rate drops in retirement, this could yield more of a tax-adjusted benefit than a Roth IRA.|
There are no income limits associated with the conversion of a traditional IRA to a Roth IRA -- anyone can convert, provided they pay the tax bill. Since the investment earnings and capital gains in your regular IRA have not been taxed yet, the government will take its share at the time of the conversion. If you have a nondeductible, traditional IRA, its earnings will be taxed but the amount of your contributions will not. The withdrawal from your traditional IRA will count as income but will not trigger the 10% penalty usually imposed on early withdrawals.
If you have a traditional IRA and are considering converting to a Roth IRA, here are a few factors to consider:
As you can see, there is no easy answer to the question, "Which IRA is best for me?" As with any major financial decision, careful consultation with a professional is a good idea before you make your choice. In addition to helping you with calculations and projections, a professional is also likely to know what, if any, changes or clarifications have been made to the complex new tax laws. Remember, your retirement could last 20 years or more. How you live tomorrow could depend on the choices you make today.
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