The basic assumptions when considering a traditional IRA versus a basic Roth IRA are the tax break advantages and when they occur. A disclaimer must be made here, because taxes, like the weather, are unpredictable from year to year and it is only possible to relate taxes to the current climate.
* the money contributed to a traditional IRA is tax-free in the contribution year up to a certain limit, but all distributions that were previously not taxed and interest earned are taxable when you receive it back
* the money contributed to a basic Roth IRA is not tax-free in the contribution year. The money earned, after 59 1/2, is tax-free when you withdraw it and all distributions of contributions are tax-free when you withdraw the funds. You do have a waiting period of five years before you can withdraw contributions without a tax bill.
Who Gains With a Roth IRA?
To consider whether you are a candidate for a Roth IRA, an estimate of your retirement tax bracket should be made. If you start at a fairly early age and contribute the maximum allowed, your interest and possibly capital gains may be considerable when the time comes to withdraw funds. If you have been accumulating wealth towards that retirement, the tax-free income from a Roth IRA may keep you from springing into a higher tax bracket.
In today’s world, exceeding $35,350 in taxable income as a single person, because of distributions from a traditional IRA, can mean an increase in your tax bracket of 10 percent. If your traditional IRA is earning less, you are in the loss column. Roth IRA distributions are included when your taxable income is calculated and you will end up owing less tax.
Who Does Not Gain With a Roth IRA?
One of the reasons for a traditional IRA is to defer taxing income until a future date. This means delaying taxing that income until the tax bracket you are in is lower than the contribution year. Retiring does often lower taxable income and the tax bracket is lower on IRA distributions as a result. It makes sense to invest in a traditional IRA if you will be paying minimal taxes on your income.
Roth IRA Mechanics
Anyone can set up and contribute to a basic Roth IRA at any time as long as you have earned income. The maximum contribution is $5,000 (or $6,000 if you are 50 or older) or the amount of your earned income, whichever is lesser. Earned income, as defined by the Internal Revenue Service (http://www.irs.gov/publications/p590/ch01.html#en_US_2011_publink1000230355), includes wages or salaries, commissions, self-employment income, alimony or separate maintenance payments and nontaxable combat pay.
You can open or contribute to a Roth IRA even if you are over retirement age. You may also withdraw all contributions after five years with no penalty. Notice, I said contributions. Taxes and penalties may come into play if you withdraw earnings before you have reached the age of 59 1/2.
Like most retirement plans, beginning young has many advantages. Considering a Roth IRA when you are young does not have the restrictions that a traditional IRA has because of the ability to withdraw your contributions at any time after five years. Of course, leaving the money in to accumulate wealth is the better choice.
Putting money in a Roth IRA when your income is lower than the upper limits is also a wise choice.
This article was written by Karl Stockton for the team at Weintraub & Selth, a firm with experience in bankruptcy law.
© 2012, Jen Carrigan. All rights reserved.