Which IRA?

Between now and April 15th, many will choose if and how they will make their annual IRA contributions. For 2014 and 2015, the cap is $5,500 and $6,000 for people age 50 or over. In choosing between a Traditional or a Roth IRA, I use a short checklist and ask three questions to start the process. The questions involve paying taxes now or later, access to savings, and freedom to stay invested. This article is for information purposes only and is not legal or tax advice.

What are IRAs?

Individual Retirement Arrangements (IRAs) are a class of financial accounts that can be set up at banks, insurance or mutual fund companies or stockbrokers. As named, their focus is on retirement savings. There are many types of IRAs. Over the next few weeks, the question for most involves choosing between Traditional and Roth IRAs.

I like to think of IRAs as special buckets for saving. They offer tax-preferred growth, a much desired characteristic for growing savings. Investment income  is not taxed, allowing savings to compound and grow faster. Savers should think long-term when using IRAs. Withdrawals before age 59 1/2 may be subject to a 10% penalty from the IRS. In contrast, savings and brokerage accounts are examples of other, albeit more leaky buckets. (Fees, for example, are another type of leak common to all types of buckets.) Although investment income is subject to tax, withdrawals from these more leaky buckets are available anytime without penalty. For long-term savings such as retirement, I prefer the less leaky IRA buckets.

IRA Checklist

Deadlines

April 15th is the deadline for most people to make a 2014 contribution. Those filing an extension have until October 15th to contribute. When making a contribution for 2014, confirm that the contribution form is completed with the proper year.

Age Limits

There is no age limit for contributions to a Roth IRA. Contributions to Traditional IRAs are for people younger than age 70 ½.

Earnings Limits

There are no earnings limits for contributions to a Traditional IRA. The tax deduction for contributions may be limited. Earning too much and coverage by an employer-sponsored retirement plan may limit the deduction.

Roth IRAs are subject to income limits. The IRS allows contributions for for married couples filing jointly with modified AGI less than $190,000 and singles below $129,000. There are “backdoor Roth IRA” strategies for high earners. These strategies involve converting balances from a Traditional to a Roth IRA. You should consult your tax advisor to learn more.

3 Questions to Get Started with Which IRA

Do I want to pay taxes now or later?

The IRS expects to collect taxes sooner or later. Traditional IRAs are the pay-later option. Contributions go into the Traditional IRAs with pre-tax dollars for those that qualify for a tax-deduction. The IRS will tax withdrawals as ordinary income when they occur. If income taxes are expected to be lower when withdrawals occur, advantage goes to paying later and Traditional IRAs.

Roth IRAs are the pay-now option. Contributions go into Roth IRAs with after-tax dollars. Yet, withdrawals are tax-free. If income taxes are expected to be higher in the future, advantage goes to paying now and Roth IRAs.

Will I need access the money before retirement?

Access is available at anytime.  The catch is that the IRS may apply a 10% penalty for withdrawals made before age 59 1/2. It will depend on the type of withdrawal, its use and if it comes out of a Traditional or Roth IRA.

The for accessing funds before age 59 ½ differ between Traditional and Roth IRA. For Traditional IRAs, penalties may apply for premature withdrawals. For Roth IRAs, it depends on what money comes out. Withdrawals of the money contributed are available anytime without penalty. Penalties may apply for withdrawals that include investment income made before age 59 1/2. The flexibility gives advantage to Roth IRAs in my opinion.

Exceptions do exist. The 10% penalty does not apply for either type of IRA under certain types of spending. They include a first home, qualified higher education expenses and hardship, such as disability.

What if I want to stay invested in an IRA?

Once again, the rules differ. For Traditional IRAs, annual Required Minimum Distributions (RMDs) rules apply at age 70 1/2. Even if there is no desire to withdraw funds, the IRS requires withdrawals. If the RMD is not satisfied, the penalty is a 50% excise tax on the amount not distributed as required.

For Roth IRAs, people can choose to maintain balances in Roth IRAs as long as they live.  Under current law, RMD rules do not apply, which can be beneficial for estate planning. Balances can keep growing in a tax-preferred manner.

There are many considerations in choosing between a Traditional and Roth IRA. Some are beyond the scope of this article. Among those discussed, it is hard to forecast changes in tax rules and regulations. The answer may be not choosing one type of IRA, but using account diversification. Both types of IRAs can be used. Candent can help you identify what is most appropriate for your situation.