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IRAs: Roth or Traditional

November 1st, 2007 at 03:59 pm

I am often asked whether it is better to contribute to a traditional, deductible IRA or to a Roth IRA. As with most personal finance questions, my answer is typically it depends. In this entry, I will provide some guidelines to help you decide which is best for you.

When I use the term IRA, I am only addressing deductible IRAs. In a future entry I will discuss why I believe that it is seldom wise to fund a non-deductible IRA.

Lets first look at the rules:

With a traditional IRA, you must be under 70 years old plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you are covered by a retirement plan, you can only deduct the full amount contributed to your IRA if your Modified Adjusted Gross Income (MAGI) is no more than $52,000 as a single tax payer or $83,000 as a joint filer.

With a Roth IRA, your Adjusted Gross Income (AGI) must be less than $99,000 as a single filer or $156,000 as a joint tax filer plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you make any deductible IRA contributions, the amount that you can contribute to a Roth IRA is further reduced by the amount that you contributed to the deductible IRA.

Based on these rules, the decision on which IRA to use is sometimes obvious:

1. If you are a single filer with an AGI over $99,000 or a joint filer with an AGI over $156,000 and you are not covered by a retirement plan, you can only fund an IRA.
2. If you are covered by a company retirement plan and your MAGI is over $83,000 but less than $156,000 as a joint filer or $56,000 but less than $99,000 as a single filer, you cannot receive full IRA deductibility, but you are able to fully fund your Roth IRA.
3. If you are over 70 and have earned income, you can only fund a Roth IRA.
4. If you are saving to buy your first home, up to $10,000 of growth and income from a Roth IRA, plus all of the contributions may withdrawn, tax and penalty free.

Now lets look at the more subtle differences between the IRA plans:

1. If you are under 40, the tax free growth combined with the tax free withdrawal of the funds (when you are over 59) often make the Roth IRA a better, after-tax investment strategy.
2. If you may need some of the funds before you turn 59, with a Roth IRA you can typically withdraw all of your contributions and pay no taxes or penalty on the withdrawal.
3. If you are over 40 and wish to pass some of your estate to your children, a Roth IRA is an excellent way to pass funds to younger generations.

When none of the above apply, the decision of funding a Roth IRA or a traditional, deductible IRA must be made by analyzing your current tax bracket, what you believe will be your future (retirement years) tax bracket and whether you expect to consume the retirement funds or pass them to future generations. This is never easy and often comes down to whether you want the tax reduction now or you can wait to get it later.

2 Responses to “IRAs: Roth or Traditional”

  1. denise Says:

    I have a question not comment, I am 50 years old just divorced and peniless. I have an income of about 42k and still one child at home age 15. I know it is a bit late but I am thinking about starting to build a small nest egg fro retirement. I get a preety decent tax return due to the minor child dependent. I am planning on putting at least half into some type of fund and building it up. Any suggestions on where I can place it to best make my money grow in 15 -20 years

  2. finabguide Says:

    It is never too late to start building a retirement nest egg. If you are sure that you can leave the money alone for 15 - 20 years, the stock market virtually always out performs over that period of time. You might want to visit the Vanguard web site, www.vanguard.com in look at their index stock offerings

    I like no-load, low cost index mutual funds and ETFs.

    For US based stocks, VFINX is the call sign for their no-load mutual fund that tracks the S&P 500 index of the 500 largest US stocks and has a annual operating cost of only 0.18%.

    For international large stocks, VDMIX tracks the MSCI EAFE Index and has an annual operating fee of 0.27%

    I believe that some exposure to the international marketplace will be increasingly important in the future.

    From your basic description, you might consider putting your funds in a Roth IRA to provide for tax free growth and withdrawal after you are 59 1/2.

    One caution, from my perspective, equities (stocks) seem somewhat over priced at this point. You might consider investing only 1/2 of your initial investment into a broad based equity mutual fund and keeping the remainder in a money market mutual fund for at least 6 months before investing the remainder in equities.

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