Traditional or Roth IRA?

If you’re thinking on starting and contributing to an IRA, you may be wondering which IRA is right for you. Generally, an individual has two IRAs to choose from – the traditional IRA and Roth IRA. This post provides some guidelines and information to help you make your decision. In some cases, based on your income, the decision is already made. In all cases, to contribute to an IRA an individual must have earned income. This is generally W2 wages, Schedule C income, and even alimony received.

Let’s start with the traditional IRA. For 2016, the maximum annual contribution amounts is $5,500 for individuals under age 50 and those 50 and over are allowed an additional $1,000 catch-up for a total of $6,500 annually. This is also true for Roth IRAs. Also, the annual maximums are the total among all IRAs. That is, if an individual is under age 50, they can have multiple IRAs, but the annual total among all of them cannot exceed $5,500 ($6,500 if age 50 or older).

Traditional IRA contributions may be tax deductible. For example, if an individual is not an active participant in an employer sponsored plan he or she is allowed a full deduction – regardless of AGI. However, if an individual is an active participant, then their deduction is subject to an AGI phase-out of between $61,000 – $71,000 if single and $98,000 – $118,000 if married filing jointly. If the individual is not an active participant but their spouse is, then the phase-out is $184,000 – $194,000. Any AGI above these phase-outs means a deductible contribution is not allowed.

Additionally, traditional IRAs do not allow contributions beyond the age of 70 ½. Furthermore, traditional IRA owners are required to take minimum distributions (RMDs) at age 70 ½. Distributions may have different taxes consequences depending on contributions made that were deductible or contributions made that were/are considered basis (after-tax contributions). Any taxable distributions are taxed as ordinary income. Generally this will consist of any deductible contributions as well as any earnings on the growth.

The Roth IRA is a bit different. Although the contribution limits are the same as traditional IRAs, Roth IRAs allow contributions after the age of 70 ½ and do not have required minimum distributions for the account owner. Roth IRA contributions are never tax deductible. However, qualified distributions are received income tax free. Additionally, individuals have access to their Roth IRA contributions at any time, without tax or penalty.

Roth IRAs are also limited to individuals with AGI below certain thresholds. For example, a single individual cannot contribute to a Roth IRA if their AGI is above $132,000 for 2016. Individuals who are married and file jointly cannot contribute to Roth IRAs if their AGI is above $194,000.

Both traditional and Roth IRAs have penalties for non-qualified distributions. The penalty is an additional 10% early withdrawal penalty in addition to ordinary income tax on earnings if there’s a non-qualified distribution before age 59 ½. Some common exceptions to the 10% penalty (but do not avoid ordinary income tax) for IRAs include death, disability, expenses for higher education and first time home purchases up to $10,000. Roth IRAs also have holding period rules. More information on the holding period rules can be found from a previous post by Jim here and by Michael Kitces at Nerd’s Eye View here.

Generally, if an individual is in a low tax bracket (such as a college graduate just starting out) a Roth IRA makes a lot of sense. The money contributed has been taxed at a lower rate and this allows the growth to be tax free in the future.

However, if an individual or couple earns too much, the Roth might not be an option. In this case, the traditional IRA is the only choice. From there, the individual needs to determine if they qualify for deductible contributions.

The good news is that regardless of which IRA an individual owns, they can contribute to the IRA and their employer sponsored plan. For example, if an individual is under age 50 and is saving to a 401(k) and Roth IRA they can contribute the maximum of $18,000 to their 401(k) and the maximum of $5,500 to the Roth IRA.