The Roth IRA presents a potentially attractive alternative to the traditional IRA long favored by many Americans as a cornerstone in their retirement planning efforts. That's because a Roth IRA allows you to potentially receive tax-free distributions of your retirement funds in return for making nondeductible contributions now.
Rules of the Roth IRA
Unlike traditional IRAs, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.
Level of contribution
Your contributions are limited to $5,500 in 2018 ($11,000 for married couples). The contribution limit begins to decline -- or "phase out" -- for single taxpayers with modified adjusted gross incomes (MAGIs) between $120,000 and $135,000 and for married couples filing jointly with MAGIs between $189,000 and $199,000. Also in 2018, Roth IRA owners aged 50 and older are able to make a catch-up contribution of $1,000.
Single taxpayers with MAGIs in excess of $135,000 and married couples filing jointly with MAGI at $199,000 or more are not eligible to contribute to a Roth IRA for 2018. A very low phase-out in adjusted gross income (MAGI) of $0-$10,000 applies to married taxpayers filing separately, which means that their contribution limit is automatically subject to a reduction on the first dollar of MAGI earned. An individual's total contributions to all IRAs, traditional and Roth, may not exceed $5,500 in 2018 plus the catch-up contribution, if eligible.
Contributions may continue beyond age 70½
Unlike a traditional IRA, your contributions to a Roth IRA may continue beyond age 70½. You are not required to start taking minimum distributions from a Roth IRA after age 70½, as you are with a traditional IRA, and you can continue to contribute as long as you continue to have earned income. When a Roth IRA owner dies, however, his or her heirs must adhere to the same minimum-distribution rules that apply to traditional IRAs.
Qualified distributions from a Roth IRA are federal income tax free. While your contributions to a Roth IRA are never tax deductible, your distributions are free of federal income tax if you have owned the Roth IRA for at least five years and meet one of the four qualifying events outlined below:
- You are at least 59½ years old.
- Your withdrawal is applied to a first-time home purchase. Such withdrawals have a lifetime limit of $10,000, provided you do not meet any of the other qualifying events listed here. (You may qualify for the "first-time home purchase" if you have not owned a home for at least two years before the date on the purchase contract or the date when construction started. You, your spouse, or a descendant or ancestor of either may qualify as the buyer.)
- The withdrawal is made to a beneficiary or to your estate as a result of your death.
- The withdrawal is made because you are permanently disabled.
The taxable portion of a nonqualified distribution may be subject to a 10% early withdrawal income tax penalty prior to age 59½. If you make withdrawals that do not meet the rules for a qualified distribution, you'll owe ordinary income taxes on the portion of the withdrawal that represents earnings, and you may also have to pay a 10% income tax penalty if you are under age 59½. Withdrawals prior to the age of 59½ that are used to pay for qualified education expenses for you or other family members are not subject to penalty tax, but you will have to pay ordinary income tax on the taxable portion of the distribution.
Qualified retirement plan "rollovers" directly to a Roth IRA are permitted, but only from Roth-style plans. So if you are changing jobs or retiring, you can roll over funds from an employer retirement plan -- such as a 401(k) account -- directly to a Roth IRA if it is a Roth 401(k). You cannot, however, transfer non-Roth style plan assets directly to a Roth IRA.
Comparing the Roth IRA with a traditional IRA
When deciding whether a traditional IRA or a Roth IRA is better for you, you'll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals.
For those whose contributions to a traditional IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a traditional IRA may be a smart choice. You should consult with your tax advisor and financial professional to assist you.
Deductible IRA contributions
If you are not eligible to participate in a company-sponsored retirement plan, you can make deductible contributions to a traditional IRA regardless of your income level, up to $5,500 in 2018. Deductible contributions may be reduced or eliminated for an individual who participates in a company-sponsored retirement plan or an individual whose spouse is an active participant in a qualified plan, depending on the amount of the taxpayer's adjusted gross income (AGI). Please refer to the article on traditional IRAs.
Converting a traditional IRA to a Roth IRA
In creating the Roth IRA, Congress included provisions for converting a traditional IRA to a Roth IRA. Conversion to a Roth IRA triggers income taxation of the amount converted to the Roth IRA attributable to all deductible contributions to a traditional IRA as well as earnings on those contributions.
If you have a nondeductible, traditional IRA, the earnings will be taxed, but the amount of your nondeductible contributions will not. The conversion amount distributed from your traditional IRA will count as income but will not affect your eligibility for a Roth IRA or trigger the 10% federal penalty usually imposed on early withdrawals.
Maximizing the benefits of the traditional IRA
The traditional IRA may still provide an advantage over the Roth IRA to those who maximize its benefit. Here's how: You invest the tax savings from your IRA deduction in a regular account each year and let that account potentially grow along with your IRA.
If you have a traditional IRA and are considering converting to a Roth IRA, consider:
- A Roth IRA may be more attractive the further you are from retirement. Why? Because the longer you have to accumulate earnings on your contributions, the larger your balance may become, which may also mean larger tax-free distributions for you and your heirs.
- If your traditional IRA contributions are nondeductible, you may be better off with a Roth IRA. That's because the distributions of earnings from your traditional, nondeductible IRA will eventually be taxed. The qualified distributions from a Roth IRA will not.
- Your current and future tax brackets will affect which IRA is best for you. For example, if you are currently in a high tax bracket and expect to be in a much lower tax bracket during retirement, a traditional IRA could be the best option. Why? Because you may be able to claim a deduction on your contributions now and then pay taxes on future distributions at the lower income tax rate later.
As you can see, there is no easy answer to the question "Which IRA is best for me?" As with any major financial decision, careful consultation with a financial professional and your tax advisor is a good idea to help you make an informed decision. Remember, your retirement could last 20 years or more. How you live tomorrow could depend on the choices you make today.
The information contained herein is general in nature and is not meant as tax advice. Consult a tax professional as to how this information applies to your situation and to determine which type of IRA may be better for you.
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GE 128561 (02/2018)