Saturday, 14 December 2019

Traditional Vs Roth IRA - Which One Should You Choose?

I'm going to be examining traditional IRAs and Roth IRAs and trying to determine which one is actually better. Or at least which one would be better for various situations. Because as a regular reader of this blog will know my favorite answer of all time is it depends. Because in the personal finance Realm, a ton of your decisions will depend on your own specific situation. And that includes the answer to the question of which type of IRA is right for you. Now I've noticed online that there's a lot of bits and pieces of information out there on the subject but nowhere that I could find where you get the whole list of differences in one place. So I'm going to make this article that place. In this article, I'm going in-depth into the differences between the Roth IRA and the traditional IRA. But before I get into the differences between the two I want to briefly touch on the ways that they're both similar.

Let's Get Started

Traditional And Roth IRA

  • Contributed To By Minors And Non-Working Spouses.
  • Must Contribute By April 15.
  • Contribution Limited To $5,500 Or $6,500 Per Year Depending On Your Age.
  • Also:
  • Union Strike Benefits
  • Long-Term Disability Benefits
  • Self-Employment Income.
  • Doesn't Include:
  • Interest & Dividends
  • Social Security Or Alimony 
  • Child Support

Both the traditional and Roth IRAs can contribute to by minors and non-working spouses as long as they meet certain special income rules. The deadline for making contributions is April 15th. And under most circumstances, as long as you have enough earned income, the amount that you can contribute each year is $5,500 if you're under the age of 50 and $6,500 if you're over the age of 50. And earning an income is basically wages, salaries, and tips in most cases. However, things like union strike benefits, or in some cases long-term disability benefits, and self-employment income in some cases is also considered to be earned income by the IRA. Things like interest and dividends, social security, alimony, or child support, those things are not considered to be earned income. 

Modified Adjusted Gross Income: (Or MAGI)

I also want to take a moment to talk about MAGI, because a lot of what I'm going to talk about later won't make sense without it. 

How Do You Find Out What Your Modified Adjusted Gross Income?

that's really a two-part question because in order to find your Modified Adjusted Gross Income you first have to find your adjusted gross income. And your adjusted gross income to put it simply is basically your gross income or the amount of money you make in a year minus any deductions that you're able to take on your tax return which can include IRA contributions, student loan interest, tuition and fees, HSA contributions, and many other things besides. Once you've got that number you have to add back in some of those deductions you took out to get your adjusted gross income to get your MAGI. Now in many cases, in fact in most cases, your adjusted gross income and modified adjusted gross income will actually be identical. However, I'll put a few things up here, and if you deducted any of those things on your tax return you would need to add them back into your adjusted gross income to find your modified adjusted gross income.

  1. Student Loan Interest
  2. One-Half Of Self-Employment Tax
  3. Qualified Tuition Expense
  4. Tuition And Fee Deduction
  5. Passive Loss Or Passive Income
  6. IRA Contribution
  7. Taxable Social Security Payment
  8. The Exclusion For Income From U.S. Saving Bonds
  9. The Exclusion Under 137 For Adoption Expenses
  10. Rental Losses
  11. Any Overall Loses From A Publicly Traded Partnership.

With that out of the way what are the differences between these two IRAs?

#1. Tax Ductions 

  • Traditional IRA: Full Contribution
  • Roth IRA: None

The first thing that everyone brings up when talking about the differences between these two types of IRAs is the difference in tax treatment. In a traditional IRA, you can deduct some or even all of your contribution to your tax return, whereas with a Roth IRA you can't.

Traditional IRA: Tax Ductions

However, one thing that people often fail to mention when talking about the tax treatment of a traditional IRA is that while in most cases you can deduct the contribution, there are some exceptions to that deduction rule. For example, if you're married filing jointly on your tax return and your spouse is covered by a retirement plan at work and, as a couple, your modified adjusted gross income is more than a $186,000 in 2017 but less than $196,000 you can only take a partial deduction on your tax return. And if your modified adjusted gross income is over $196,000, you actually can't take any deductions. This is the case even if you yourself are not covered by a plan at work. Now if you're the one that's covered by a retirement plan at work instead of your spouse the rules are slightly different. If you're single or filing as head of the household and you make between $62,000 and $72,000 a year you can claim a partial deduction, but if you make more than $72,000 then you can't claim any deduction for that year.

If you are married filing jointly or you're a qualifying window or window, then you can claim a full deduction as long as you make $99,000 a year or less. If you make more than $99,000 but less than $119,000 then you can claim a partial deduction. And of course, anything more than that will stop you from claiming any deduction.

Roth IRA: Tax Deduction

Of course, you can't deduct your contribution for a Roth IRA, that's really the heart of the difference between the two. Roth IRAs are taxed now but can be pulled out tax-free later, whereas a traditional IRA is usually tax-deferred now but then it would be taxed later when you pull the money out.

#2. Age Restrictions

  • Traditional IRA: Age Restrictions Under 70½
  • Roth IRA: Any Age

A couple of other differences between the two plans is the ages at which you can actually contribute to the IRA. For a Roth IRA you can actually contribute at any age, however for a traditions IRA you have to be under the age of 70½ in order to contribute.

#3. How Much You Can Contribute.

I don't mean the contribution limits per year, under normal circumstances they're both the same as I said before. I'm referring to some other contribution limitations on Roth IRAs specifically. You see in 2017 if you're filing as single or head of the household and your modified adjusted gross income is more than $118,000 but less than $133,000 then you can only contribute a reduced amount to your Roth IRA. And I will give you an example of how to calculate that in just a second. If your Modified adjustment gross income is over $133,000 then you can't contribute anything to the Roth IRA that year. If you're married filing jointly or a qualifying widow or widower making between $186,000 and $196,000 a year you can contribute a reduced amount and anything above $196,000 would stop you from contributing to a Roth all together.

Backdoor Roth IRA

There's one exception known as the backdoor Roth IRA which is basically where you contribute money to a traditional IRA but then converts it to a Roth IRA. In order to figure out how much you can contribute to a Roth IRA (assuming you're not going to use the backdoor method) I'm going to use an example. 

Let's say that Bob is a single 45-year-old lawyer he's doing pretty well for himself with a modified adjusted gross income of $120,000 per year. As a result, he does fall in between the $118,000 and $133,000 limits for a reduced contribution to the Roth IRA. How does Bob figure out how much he can put in?

  • Step 1: Subtract Lower Limit Threshould Of Reduced Contribution From Modified adjusted gross income
  • $120,000 - $118,000 = $2,000
  • Step 2: Divided by $15,000 ($10,000 if he were married)
  • Step 3: Multiply 0.1333 by his contribution
  • Step 4: Subtract result from normal contribution limit. $5,500 - $733.33 = $4,766.67

First, he has to start with his modified adjusted gross income, and then because he is filing he must subtract $118,000 from the modified adjusted gross income (it would be $186,000 if you were married filing jointly). This leaves him with $2,000 leftover, he must then take that divided by $15,000 (or $10,000 if he were married filing jointly). Why? I don't know it's just how the laws work. That leaves him with 0.1333 and so on. He must then take that and multiply it by his contribution limit. Which since he's 45 years old would be $5,500. If he were over 50 years old it would be $6,500. But he's not so.133 times $5,500 leaves Bob with $733.33. And then the last step for Bob is to take his contribution limit of $5,500 and subtract that $733.33. This leaves him with his reduced contribution limit for the year at $4,766.67.

#4 Penalties

Roth IRA: 10% Penalty On Withdrawals Of Earning Only

If you have a Roth IRA then you wouldn't pay penalties for withdrawal taken before the age of 59½ as long as those withdrawals are not more than the total amount you've contributed yourself to the IRA.  Let's say if Bob from earlier had invested $5,500 a year into his IRA for the last 10 years, he would have contributed a total $55,000 and he could now take up to that $55,000 out without incurring any penalties. However, if he took any more than that you would be hit with the 10% Federal penalty tax on the withdrawal of earnings in the IRA. Let's say he had a few huge medical bills and withdrew $60,000 from his Roth IRA. He wouldn't get penalized on the first $55,000 that he took out because they were his own contribution, however on the last $5,000 he would be hit with a 10% penalty which would be worth $500.

Traditional IRA: 10% Penalty On All Withdrawals Before Age 59½

Whereas in a traditional IRA there's a 10% Federal penalty tax on withdrawals of both your contribution and your earnings before the age of 59½. If someone wants to take that same $60,000 out of traditional IRA they would be tax 10% on the whole $60,000 or $6,000. But of course, it's finance so there's always an exception. And in this case, your withdrawal may not be subject to the penalty tax if it's due to any of the following reasons you see below

  1. Your Disability Or Death
  2. If They're Being Distributed To A Reservist Who Was Called To Active Duty For More Than 179 Days
  3. If It's For A First Time Home Purchase Up To A Maximum Of $10,000
  4. If It's For Post-Secondary Education Expenses
  5. If It's For Substantially Equal Periodic Payments Under The IRS' Guidelines
  6. Certain Underimbursed Medical Expense
  7. An IRS Levy
  8. Health insurance Premiums As Long As You've Already Received 12 Consecutive Weeks Of Unemployment Compensation.

Yeah fiance laws are unnecessarily complicated sometimes

#5. Required Minimum Distributions

  • Roth IRA: None
  • Traditional IRA: Start The April 1st After You're 70½ Years Old

The Roth IRA has no required minimum distributions, but you must take a certain amount of money out of your traditional IRA starting on April 1st of the year following the year you reach age 70½. So for example, if your 70th birthday is on May 20th, then you will be 70½ years old in November of that year, meaning, you would need to take a required minimum distribution from your IRA the following April 1st. And then for every year after that, you need to take it by December 31st. The amount of the required minimum distribution varies depending on your life expectancy. 

Inherited IRA

Assume The IRa

The last thing that I want to talk about is inherited IRAs. There are three ways to inherit an IRA if you're the account owner's surviving spouse. You can either do what they call (assuming the IRA) as long as you're the only beneficiary on the account. And basically, how the IRS treats it if you choose these options is they assume that the IRA you received was yours along. This means that you can add your own contribution to it and if it's a traditional IRA you won't have to take any required minimum distributions until the year after you turn 70½ like we just discussed before.

"Inherit" The IRA

The second option is to inherit the IRA. Which could have needed better I mean come on, why is it that if you inherit an IRA, inheriting the IRA is a term used for one of your three options. They could have made that clear... Anyway "inheriting" an IRA basically means that you're going to transfer the amount in the IRA you received into a different IRA that is in your name. Now if you do this you will have to be taking the required minimum distributions in the year following the previous IRA owner's death. This can be good if your spouse needs money right away, but it also means that the IRA won't grow quite as much because you're no longer able to just keep letting it appreciate. 

Disclaimer The IRA

Which basically means you just refuse to accept it either in part or in full. But you're going to really want to fully think through the ramifications before doing that because typically if you disclaim an IRA you can't change your mind later. Now if you're not the account owner surviving spouse, you can still either inherit or disclaim it, however, if you choose to inherit it you must start taking the required minimum distributions right when you inherit it under these circumstances. 

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