Traditional IRAs vs. Roth IRAs--Which is Right for You?
One of the most talked-about sections of last year's new tax law is the one establishing Roth IRAs. Starting this year, you can open a Roth IRA, which differs in several important aspects from a traditional IRA. The following information about traditional and Roth IRAs can help you determine if either or both types of IRAs should be part of your retirement planning.
Anyone under age 70 1/2 with earned income, regardless of income level, is eligible. A nonworking spouse also can contribute.
The maximum amount a person can contribute is $2000, reduced by any contributions made to a Roth or any other IRA (except an Education IRA). However, if a person's earned income for the year is less than $2,000, then the maximum contribution would be the earned income amount. A nonworking spouse also can contribute up to $2,000 if the earned income amount is at least $4,000.
Deductions and Employer-sponsored Plans
Generally, contributions to an IRA are fully deductible if a taxpayer and his or her spouse are not active participants in an employer-maintained retirement plan (including Keoghs), for any part of the plan year ending within the taxpayer's tax year. However, there is an exception to the rule: A taxpayer and/or spouse who participates in an employer-maintained plan can make fully deductible IRA contributions if adjusted gross income (AGI) is below certain levels.
Previously, the AGI levels were $40,000 for married couples filing jointly, and $25,000 for single filers. If AGI was above those levels, the IRA deduction was phased out and no deduction was allowed once AGI reached $50,000 and $35,000 for married couples filing jointly and single filers, respectively. But, two key provisions in the new tax law now make it possible for more people to deduct their annual IRA contributions.
New Law: Under the new law, the income ranges over which the $2,000 IRA deduction limit is phased out have been increased. These increased amounts will be phased in starting this year:
- Until 2005 when the income limit will be $50,000 (phasing out completely for AGI of $60,000 or more) for single filers
- Until 2007, when the limit will be $80,000 (phasing out completely for AGI of $100,000 or more) for joint filers.
- For 1998, the deduction begins to phase out for single filers with income levels of $30,000 or more, and for joint filers with income levels of $50,000 and more.
In addition, the new law removed the deduction limits for spouses of individuals who are in employer-sponsored plans. Now, the deduction for the spouse who is not in an employer-sponsored plan is done without regard to the other spouse's active participation in an employer-sponsored plan. The combined AGI for the two spouses must be less than $150,000; the deduction phases out for AGI between $150,000 and $160,000.
For example: X is an active participant and Y is not. Their combined AGI is $200,000. Neither is qualified to make deductible contributions to an IRA, because their combined AGI is more than $160,000. Suppose, however, that their combined AGI is $110,000. Then Y, who is not an active participant, can make a deductible contribution of up to $2,000. X, however, cannot, because the combined AGI exceeds the dollar limit for an active participant filing jointly ($50,000 for 1998).
If a taxpayer is not eligible to make deductible contributions to an IRA, he or she can still make nondeductible contributions, which are subject to the same contribution limits.
Withdrawing Funds from a Traditional IRA
You can take distributions penalty-free as early as age 59 1/2. You also can wait to take your distributions, but distributions must begin when you reach age 70 1/2. Earnings on the money contributed into the IRA are not subject to tax until they are withdrawn.
New Law: The new tax law also added two new exceptions to the 10% additional penalty tax on early distributions. Prior to reaching age 59 1/2, you may make withdrawals penalty-free to help pay for qualified higher education expenses or the purchase of a first home. Higher education expenses include post-secondary tuition, fees, books, supplies, required equipment, room and board, and graduate courses.
A qualified first-time home buyer distribution includes any IRA distribution, up to $10,000, that is used within 120 days to pay acquisition costs of a principal residence of a first-time home buyer. The first-time homebuyer can be the IRA owner, the owner's spouse, child, grandchild, or ancestor. A first-time homebuyer means an individual who has no present ownership interest in a principal residence, and had no such interest during the two-year period ending on the date of purchase of the new principal residence.
Individuals of any age, with AGI below $110,000 for single filers and $160,000 for those married filing jointly, are eligible. The contribution limit is phased out for single filers with AGI between $95,000 and $110,000, and for joint filers with AGI between $150,000 and $160,000.
Maximum Contributions and Deductions
Unlike a traditional IRA, contributions to a Roth IRA are not deductible against current income. But, the AGI limit is higher than for traditional IRAs, even if you are covered by an employer-sponsored plan. Like traditional IRAs, you are allowed to make a maximum contribution of $2,000 per year to your Roth IRA. However, your contributions to all your IRAs, including a Roth IRA (but not Education IRAs), are counted toward the $2,000 maximum. If your compensation is at least $4,000, your nonworking spouse can also make a $2,000 contribution.
Withdrawing Funds from a Roth IRA
Unlike traditional IRAs, distributions from Roth IRAs are tax-free if they are received five years after your initial contribution, and upon reaching age 59 1/2, becoming disabled, purchasing a first home, or upon death. The amount of the distribution that is tax-free includes not only your contributions, but also all earnings on those contributions. Furthermore, there are no minimum distribution requirements, and contributions can be made to your Roth IRA even after you reach age 70 1/2, as long as you have earned income.
Because there is no mandatory withdrawal schedule, your Roth IRA can continue to grow tax-free, and you can continue to contribute to it. If you decide to take a distribution before age 59 1/2, the distribution will first be made out of your contributions, so they won't be subject to tax. However, once you exhaust the amount you contributed, and begin withdrawing the earnings, you will be taxed on the earnings.
In most cases, you will have greater future tax benefits with a Roth IRA even though you don't get the benefit of a deduction in the year you made the contribution.
Other advantages to a Roth IRA
A Roth IRA is a good way to fund a future expense, such as the purchase of a home. Remember, you can withdraw all your contributions tax-free after five years, even if you have not reached age 59 1/2. This allows you to use your contributions as you need to, but still have the earnings continue to grow as a part of your future retirement fund.
Rolling Funds into a Roth IRA from a Traditional IRA
This is an important issue for many who qualify for a Roth IRA--whether to roll over some or all of a traditional IRA into a Roth IRA. You may do so in any year that your AGI is less than $100,000. This AGI limit applies to both single and married filing jointly taxpayers. However, married taxpayers filing separately are not eligible for this rollover. The amount that you roll over is taxable at the time of the transaction, but if the rollover is made prior to January 1, 1999, you may include it in your income ratably over four years.
If eligible, you should consider this option if you: 1) currently have a nondeductible IRA, 2) can afford to pay the tax on the rollover amount, and 3) don't anticipate withdrawing funds for at least five years.