Wednesday, May 1, 2013

Traditional IRA vs Roth IRA

As you save money for retirement, you may be confused about whether you would be better off sticking with a traditional IRA or moving your money to a Roth IRA, instead.  Both are great retirement tools, and there are advantages to each.  Recently, the April, 2013 edition of the AARP Bulletin addressed this very question (pg. 28). While there is no answer that is right for everyone, learning a few important facts about each type of retirement savings plan may help you make the decision that will work best for you. Here is some information that will help you compare the two.

Traditional IRA

The traditional IRA is what most of are are accustomed to using for our retirement savings.  They are a great way to save tax deferred income that you will be able to withdraw when you retire.  Here are some facts you should know about this type of savings:

You can put $5500 a year in an IRA or $6500 if you are age 50 or older.

When you initially invest the money in the IRA, that money is not subject to income taxes.  This reduces the amount of taxes you owe in the current year.  The taxes are deferred until you withdraw the money. This will reduce your tax liability during your working years, which can be a major benefit to families who want to save for retirement and reduce their taxes at the same time.

However, if you make early withdrawals, they may be subject to taxes and penalties (there are some exceptions).  When you die, any remaining money that is passed on to your heirs is also subject to income taxes.

You will not pay income taxes on the money until you begin to withdraw it when, presumably, you will be taxed at a lower tax rate than you currently pay.  On the other hand, once you do begin to withdraw your IRA savings, the additional income could increase the tax rate some people actually do pay on their retirement income.  In other words, if your Social Security income alone is low enough that you would not be required to pay taxes on it, adding annual disbursements from your IRA could mean that more of your income is subject to taxation.  This will not apply to everyone, but it could apply to people who will be withdrawing large amounts from their IRA's.

Mandatory withdrawals are required beginning at age 70 1/2.  You can no longer contribute to a traditional IRA after that time.

Roth IRA

The Roth IRA works quite differently and is an excellent retirement option for people who expect that their tax rate will be about the same after retirement as it is now.  However, the taxes on the money that is invested in a Roth IRA are not deferred.  Savers must be willing to pay income taxes on the money during the year the money is earned.  Here are some additional facts you will want to know about a Roth IRA:

You can invest up to $17,500 this year, and $23,000 if you are age 50 or older.

As mentioned above, when you put the money in your Roth IRA account, you will still include it as part of your earnings on this year's tax return, and you will pay income taxes on it.

The Roth IRA has the advantage that you can make early withdrawals at any time, without penalty, so you can treat your Roth IRA as a savings account.  Since you already paid taxes on the principal, you do not owe taxes or penalties on your initial investment when you withdraw it.  In addition, if you hold the money in your IRA for at least five years and you reach the age of 59 1/2, the dividends and capital gains you earned  on the money over the preceding years will be also be tax free when you withdraw these funds.  

Paying the taxes up front can be a big advantage if you expect to hold the investment for a long time and you believe that your investments could increase substantially in value.  This can potentially give you the income you need in your later years while keeping your tax rate low.  In addition, your heirs can inherit the funds tax free.

You do not have to withdraw your money at age 70 1/2.  In fact, if you are still working at that age, you can continue to contribute to the Roth IRA.  

Can You Change Your IRA Designation?

If you have money in a traditional IRA and you want to put it into a Roth IRA, it is possible to make the change as long as you are willing to pay taxes on the money during the year when you make the transfer. 

If you don't want to pay taxes on all the money you have in your traditional IRA in one year, you can spread the transfer out over several years.  

Which IRA is right for you?  That depends on many factors.  As always, you would be wise to discuss this decision with your CPA and your investment adviser.  No one choice is right for everyone.

If you want to learn more about factors that could affect your retirement planning, you may also be interested in reading the information in the index articles listed below.  Each one contains links to a number of helpful articles on that topic.

Gifts, Travel and Family Relationships

Great Places for Boomers to Retire Overseas

Great Places to Retire in the United States

Health and Medical Topics for Baby Boomers

Money and Financial Planning for Retirement

You are reading from the the blog:  http://baby-boomer-retirement.blogspot.com

Photo courtesy of www.morguefile.com
 

4 comments:

  1. Great tips! I am on the verge of retirement,I won't reveal my age I'll let you guess hahaha! Thank God I was ahead of the curve and set up a checkbook ira financial plan. Now I'm able to enjoy my retirement without the burden of worrying about financials.

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  2. This couldn't have been a more timely article. We were just thinking about a Roth. Very helpful and informative article.

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  3. We made the switch from a traditional IRA to a Roth IRA a couple of years ago. Even though we had to pay the taxes the year we made the switch, we felt it was worth it because we didn't want to start taking out our money at age 70 1/2. We hope to let our savings grow a little longer, so it seemed like the right decision for us. I'm glad this information has benefited others, too.

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  4. At http://www.mutualfundstore.com/individual-retirement-account-ira, you can learn a lot more about IRAs and what they entail. It's good to get a start, especially when you are a little bit younger, but any time you get going, this is a good way.

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