Saturday, February 15, 2014

To Roth or Not To Roth (an IRA)? A Classic Shakespearean Conundrum!



Are you wondering what Hamlet, has to do with Individual Retirement Accounts (IRA)? I have an answer for that!! Recently revisiting the Shakespeare play 'Hamlet' and listening to the opening of the soliloquy in the "Nunnery Scene", "To be, or not to be, that is the question--" etc., I wondered how many times we face the same questions albeit in not such dire straits as Hamlet! 

The question I get asked most of the time in my practice, is whether to pick a Traditional IRA or a Roth IRA! Let's quickly touch upon the basics:

Who Can Open A Traditional IRA:  According to the IRS' Pub 590, "You can open and make contributions to a traditional IRA if: 
  • You (or, if you file a joint return, your spouse) received taxable compensation during the year, and; 
  • You were not age 70½ by the end of the year.

You can have a traditional IRA whether or not you are covered by any other retirement plan. However, you may not be able to deduct all of your contributions if you or your spouse is covered by an employer retirement plan. 

If both you and your spouse both have compensation and are under age 70½, each of you can open an IRA. You cannot both participate in the same IRA. If you file a joint return, only one of you needs to have compensation.

Who Can Open A Roth IRA:  A Roth IRA is an IRA is subject to the same rules that apply to a traditional IRA except as explained below:

  • You cannot deduct contributions to a Roth IRA.
  • If you satisfy the requirements, qualified distributions are tax-free.
  • You can make contributions to your Roth IRA after you reach age 70 ½.
  • You can leave amounts in your Roth IRA as long as you live.
  • The account or annuity must be designated as a Roth IRA when it is set up.
Differences Between The Two: So what can be deduced from the above information? 

The tax breaks for the Traditional IRA are immediately seen in the year of deposit. Also, the earnings on the contributions are not taxed until withdrawals are made from the account. 

Say for example, you made $50,000 during the year, and you put the maximum $5,500 of it in an IRA for 2013. You will be taxed on $44,500. And the $5,500 grows tax-free till withdrawal ad only at that point it will be taxed at your tax rate. If the funds are withdrawn before you turn 59 and 1/2, you will pay income-tax AND 10% penalty on the earnings accrued. Penalties may be waived only in certain circumstances. 

The tax breaks for the Roth IRA are not seen immediately in the year of deposit since contributing into it is not tax deductible. However the earnings in the account do grow tax deferred. 

In the above example, for making a Roth IRA contribution, the taxpayer would still pay taxes on the entire $50,000. The big difference to remember between the two, are the words TAX EXEMPT. In other words, a Roth IRA offers tax exempt rather than tax deferred savings. 

Both the types accumulate savings without paying taxes on the earnings, the Traditional ultimately sticks you with tax for those (plus the contributions) when withdrawn. The Roth does not. As long as the Roth rules are followed, you never pay taxes on the gains. Also, the Roth contributions are phased out at higher amounts than for Traditional. 

On the Roth, you can withdraw your initial contributions free of taxes at any time without penalty. You can also pull out both earnings plus contributions penalty free if pulled out under certain circumstances. However, do keep in mind that profits withdrawn before retirement age, and before the money has been in the Roth for at least 5 tax years will be taxed. You'll also incur a 10% penalty when the earnings are withdrawn before age 59 1/2. 

Traditional IRAs can be converted into Roth IRAs. Please contact a tax professional to advise you in this regard. 

Bibliography: Publication 590

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As always, read my disclaimer here. Please consult a qualified tax professional for your unique tax needs. 
More of my contact information is on my website, www.mntaxsolutionsllc.com