Roth versus Traditional IRAs

by Dual Income No Kids on September 1, 2009 · 0 comments

Traditional IRAs are great, but they do have some restrictions that make them less palatable to the common investor. An alternative to the Traditional IRA is the Roth IRA, which, while still a retirement account that shares many common properties with the Traditional IRA that we’re all familiar with, has some advantages that make it an attractive investment vehicle.
History
The Roth IRA is named after the former Delaware Senator William Roth. Senator Roth worked intensively on the Taxpayer Relief Act of 1997, which went into effect beginning in 1998. The Taxpayer Relief Act of 1997 was born out of the House Republican’s “Contract with America” which was vetoed by then-President Bill Clinton in 1995. After being signed into law, loopholes in the Roth IRA specification were quickly identified: an individual was allowed to convert a Traditional IRA to a Roth IRA, then make withdraws from the Roth IRA immediately, thus avoiding the 10% penalty associated with taking an early withdraw from a Traditional IRA. These loopholes were closed legislatively in 1998, and the Roth IRA that is in the current U.S. tax code has been largely unchanged since then.
Tax Structure
So what differentiates a Roth IRA from a Traditional IRA? What really separates a Roth IRA from other types of retirement investments is how it is structured from a tax standpoint. A Traditional IRA’s qualified contributions are tax-deductible, unlike contributions made to a Roth IRA. With a Traditional IRA, anyone making any amount of money is allowed to make a contribution to their IRA, allowing them to defer paying taxes on the earnings resulting from their investments. However, not all contributions from all income groups are tax-deductible. Both IRAs use what is referred to as the Modified Adjusted Gross Income, which is a fairly complicated value that is dependent on the context from which it is invoked, but generally speaking, it is your gross yearly income minus any deductions for which you qualify. With a Traditional IRA, you must first meet the minimum Modified Adjusted Gross Income (MAGI) limit, which means you must have taxable, non-investment, income. If you do not meet that requirement, then your deductible contributions are limited to be equal to your non-investment income for that year. Assuming you meet the minimum MAGI requirements, your filing status determines how much of your contributions are tax-deductible. If you’re married filing jointly or a qualified widow then you can take the maximum deduction up to a MAGI of $85,000 and you can continue to take a percentage of the maximum deduction until your MAGI exceeds $105,000. If you’re married filing separately, then you the maximum deduction limit is $0 and the maximum MAGI that you’re allowed to still take a deduction is $10,000. If you’re single or head of household, then the maximum deduction limit is a MAGI $53,000 and the deduction upper limit is a MAGI of $63,000. You’ll notice from looking at those values that the MAGI appears to be kind of low, especially for those with married filing separately status. It’s also worth noting that these values are valid if you are already covered by a qualified plan through your employer. If you are not, then then you can take a full deduction at any income level.
Roth IRAs don’t have tax-deductible contributions, but they do have a limit on what income levels can contribute. Roth IRAs are a bit more accommodating than Traditional IRAs for a wider range of income levels. They were originally developed to help the middle class save for retirement, and their income eligibility requirements reflect that goal.

Roth IRAs have the same minimum MAGI limit requirement that Traditional IRAs have, and they have different eligibility requirements based on your MAGI. If you’re a single filer you’re eligible to make a full contribution if you have up to $105,000 MAGI, or up to $120,000 for a partial contribution. Joint filers are restricted to having $166,000 and $176,000 MAGI for the maximum and partial contribution requirements, respectively. Those filing as married filing separately have limits of $0 and $10,000.

Additionally, Traditional IRAs and Roth IRAs have a maximum amount that you’re allowed to contributed per year. If under 50 years old, you are only allowed to contributed a maximum of $5,000 total spread across whatever IRAs you’re eligible for (meaning you can’t contribute $5,000 to a Roth IRA and then $5,000 to a Traditional IRA; the sum total of all contributions to all IRAs must be less than $5,000). If you’re over 50 years old, then you can increase that amount by $1,000.
Advantages
The biggest advantage of using a Roth IRA is its withdraw policies. Any contribution to a Roth IRA can be withdrawn penalty-free as long as the withdraw occurs at least five years after the initial investment, even if that initial investment was a roll-over from a Traditional IRA. Conversely, withdraws from Traditional IRAs are subject to income tax and are also subject to a 10% penalty if made before you turn 59 1/2 years old. Additionally, there are a number of penalty-free exceptions that include paying for: education expenses, medical expenses and the purchase of your first home, among others. Withdraws are not included in your yearly gross income, as they have already been taxed, whereas Traditional IRA distributions are taxed.
Regardless of which investment vehicle you favor, there are going to be advantages and disadvantages. The tax implications and withdraw policies make Roth IRAs an attractive retirement investment, and if you’re eligible you should definitely look into opening one. They can be a great vehicle to both build and conserve your wealth. As with any investment, if you are unsure about whether you qualify or if a Roth IRA is a good fit for your particular financial situation, you should consult a professional financial advisor whom you trust. If you want to do some additional research on your own, you can go here.
-Michael

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