Traditional or Roth IRA, which should you choose?
Published 12:55 am Sunday, September 16, 2007
Because both Roth IRAs and traditional IRAs present compelling advantages, individual circumstances typically determine which choice is best for a given investor. The decision requires a careful analysis of eligibility rules, tax issues, distribution requirements, and regulations governing rollovers from employer-sponsored plans.
Elements in Common
Before exploring the differences between Roth IRAs and traditional IRAs, it is worthwhile first to review the attributes they share, such as maximum annual contribution limits. For the 2007 tax year, the maximum annual contribution to either a traditional or Roth account is $4,000, with an additional $1,000 contribution permitted for investors aged 50 and older. If you have not already made a contribution for the 2007 tax year, you may do so any time until April 15, 2008. For the 2008 tax year, the maximum annual contribution increases to $5,000, with the catch-up contribution remaining at $1,000. Nonqualified withdrawals before age 59 1/2 are subject to federal income taxes and, potentially, an additional 10 percent withdrawal penalty.
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Regardless of which IRA you maintain, you are likely to have a wide range of investment choices. You may elect stocks, bonds, cash investments, or some combination of the three, depending on your risk tolerance and time horizon.
Who Is Eligible?
The IRS has established eligibility criteria depending on income and age. Anyone with earned income can establish or contribute to a traditional IRA up to age 70 1/2. Investors are eligible for a Roth IRA only if they meet certain income thresholds described.
In addition, contributions to a Roth IRA may continue beyond age 70 1/2 as long as an investor has taxable income.
Taxes and Distributions
Tax distinctions between traditional IRAs and Roth IRAs, as well as distribution rules, are important considerations when choosing between the two. Contributions to a traditional IRA may be tax deductible depending on an investor’s modified adjusted gross income (MAGI), filing status and whether he or she contributes to an employer-sponsored plan at work. Traditional IRAs are also subject to minimum distribution rules, whereby investors must begin required minimum distributions (RMDs) on an annual basis once they reach age 70 1/2. The amount of the distribution is based on the value of the account, the life expectancy of the investor and, potentially, the investor’s beneficiary. RMDs are taxed as ordinary income, but not all of the distribution is taxable if nondeductible contributions were made.
With a Roth IRA, contributions are not deductible, regardless of an investor’s income. Qualified withdrawals are tax free as long as an investor has maintained the account for at least five years and is age 59 1/2 or older, and RMD rules do not apply to Roth IRAs. For many people, a Roth IRA may result in more after-tax income during retirement because of the tax-free status of qualified withdrawals.
A Look at Rollovers
As the baby boomer generation approaches retirement and many workers continue to change jobs frequently, rolling over assets from an employer-sponsored plan to an IRA is likely to take on greater urgency. For 2007, tax laws permit direct rollovers from traditional employer-sponsored plans, such as a traditional 401(k), to a traditional rollover IRA. A direct rollover, in which an investor authorizes a plan sponsor to transfer funds directly to the financial institution acting as custodian of the rollover IRA, preserves the account’s tax-deferred status until an investor begins RMDs.
Currently, direct rollovers from employer-sponsored plans to a Roth IRA are only permitted when the plan is a Roth account, such as a Roth 401(k). Beginning in 2008, direct rollovers from non-Roth plans to Roth IRAs will be permitted. However, income taxes will be due on all proceeds because the rollover will be considered a conversion from a traditional account to a Roth account, which typically triggers tax payments. A qualified tax advisor can help you sort through the details.
There are additional rules governing IRAs, including regulations that permit penalty-free withdrawals for qualified educational expenses and the purchase of a first home. Because the rules are complex, consult a financial advisor before making final decisions.