How to Pick an IRA That's Right for You

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One of the most common questions I hear from clients is whether they should invest in a traditional IRA or a Roth IRA.

Let’s start with an understanding of the difference between the two. The biggest difference between a traditional IRA and a Roth IRA is when you pay taxes.  I like to think of it as “pay me now or pay me later” and with the IRS, there is no free lunch. Generally, contributions to a traditional IRA are deductible in the year they are made, but you must pay regular income tax upon distribution.  Contributions to a Roth IRA are not tax deductible when the contribution is made and you don’t pay taxes upon distribution.

In 2013 you can make an IRA contribution of up to $5,500 plus a $1,000 catch-up contribution if you are over 50. You have until your tax filing date, not including extensions, to make a contribution for the previous year. You can contribute to a combination of both a Roth IRA and a traditional IRA as long as the total does not exceed the limit. IRA contributions must come from earned income.  A non-working spouse can make an IRA contribution of up to $5,500 ($6,500 if over 50) if the working spouse earns enough to cover the contribution and a joint return is filed.

There are some restrictions on when you and your spouse can contribute to an IRA. If you are eligible for an employer-sponsored retirement plan and your modified adjusted gross income is over a set limit, you cannot contribute to a tax-deferred, traditional IRA. In 2013, your eligibility for a tax-deferred IRA begins to phase out at $59,000 if you are single, and at $95,000 if you are married filing jointly. The phase-out for a non-working spouse begins at $178,000. However, if you earn too much for a deductible IRA, you can contribute to a non-deductible IRA. There are also income limits on Roth IRAs. In 2013, your eligibility to contribute to a Roth IRA begins to phase-out at a modified adjusted gross income of $112,000 if you are single, and $178,000 if you are married filing jointly.

IRAs are designed to encourage saving for retirement, so there are restrictions on when you can take distributions. Generally, you cannot take distributions from a traditional IRA before age 59½ without a 10% penalty. Roth IRA contributions can be withdrawn any time, tax free. Earnings on Roth IRAs can be withdrawn tax free after you reach age 59 ½, and the money has been invested for a least five years. There are some exceptions to the rules on early withdrawal penalties. The most commonly used exceptions are to purchase your first home or to pay for qualified education expenses. With a traditional IRA, you must begin taking a required minimum distribution (RMD) at age 70½. There is no RMD for Roth IRAs.

Choosing the right IRA starts with your eligibility to make a contribution, given your income and access to an employer-sponsored plan. If you pass this hurdle, the next consideration is your current tax rate, your anticipated tax rate in retirement and your investment timeframe.  If you are in a high tax bracket now, and anticipate being in a lower tax bracket in retirement, a traditional IRA may be your best option. If you are currently in a lower tax bracket, and you have long time horizon, a Roth IRA may be your best option. Additionally, a Roth is the best choice if you want easy access to your money before retirement.  You can withdraw your entire Roth contribution anytime, tax free. However, you may find the 10% penalty to be beneficial in discouraging you from spending your IRA before retirement. A Roth can also be advantageous if you already have a lot of money in a traditional IRA or 401k and you need some tax diversification.

A Roth IRA can be a good choice if you plan to bequeath the IRA to your family.  No RMD is required, so the account can continue growing throughout your retirement years. Upon inheritance, your heirs will not owe income tax on your contribution or on earnings, if the Roth was held for at least five years. However, the Roth IRA is part of your estate and estate tax may be due if your total estate exceeds $5.25 million.


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