Individual Retirement Accounts can be part of the foundation of a
financially secure retirement. For many years, millions of individuals have
made annual contributions to IRAs or used them to receive distributions from
retirement plans on changing jobs or retiring. A few years ago, a new form of
IRA was created called the Roth IRA. The Roth IRA offers some advantages over
the traditional IRA but comes with some limitations.
Here is a comparison of some of the key features of each.
Eligibility
Anyone under the age of 70 ½ with earned income can contribute to a
traditional IRA. For a Roth IRA, you must still have earned income but there
is no age restriction. However, there are income limits for Roth IRAs. Single
tax return filers can make full contributions if their income is less than
$95,000. The limit for joint filers is $150,000. Partial contributions are
allowed if your income exceeds those amounts (up to $110,000 and $160,000
respectively).
Taxability of Earnings
Earnings on funds in a traditional IRA are tax deferred. Roth IRAs provide
for tax-free growth.
Contribution Limits
The contribution limits for both types of IRAs are the same. In all cases,
contributions must not exceed earned income.
- 2003 to 2004 contributions - $3000
- 2005 to 2007 contributions - $4000
- 2008 contributions - $5000
- After 2008, the limits will be adjusted for inflation in $500
increments.
In addition, workers ages 50 and over can make additional "catch-
up" contributions of $500 in years 2003 to 2005 and up to $1000
thereafter.
Deductibility of Contributions
Contributions to traditional IRAs are deductible if you do not participate
in another qualified plan. If you are a plan participant, contributions may
be deductible depending on your adjusted gross income.
For 2004 contributions - Single return filers - full deductibility if
Adjusted Gross Income is $45,000 or less and partial deductibility with
Adjusted Gross Income up to $55,000. For joint return filers, the limits are
$65,000 and $75,000.
For 2005 contributions - Single return filers - full deductibility if
Adjusted Gross Income is $50,000 or less and partial deductibility with
Adjusted Gross Income up to $60,000. For joint return filers, the limits are
$70,000 and $80,000.
Contributions to a Roth IRA are not tax deductible.
Taxability of Withdrawals
For traditional IRAs, any earnings and deductible contributions are subject
to tax on withdrawal. All distributions from a Roth IRA are tax-free.
Penalty for Early Withdrawals
Both types of IRAs impose a 10% early withdrawal penalty tax on
distributions taken before reaching age 59 ½. There are a few exceptions
for death, severe hardship and other situations.
Mandatory Distributions
For a traditional IRA, you must start taking distributions in the year you
reach age 70 ½. There are no required distributions for the Roth
IRA.
Which IRA is right for you?
If your income level precludes you from getting a deduction for
contributions, the answer is easy - choose the Roth IRA.
If your contributions to a traditional IRA would be deductible, the
question is harder. Generally, if you are younger, the attraction of tax-free
distributions would outweigh the immediate benefit of the deductions. If you
expect your marginal tax rates to remain at their current level or increase,
the odds favor the Roth IRA.
If you have significant other assets and would like to use your IRA to
pass significant wealth on to future generations, the tax-free nature of the
Roth IRA is extremely attractive.
Should You Convert Your IRA to a Roth IRA?
There are some special rules that enable you to convert a regular IRA into
a Roth IRA. Many people find that the attractions of tax-free distributions
and no required distributions make a Roth IRA conversion worth considering.
However, there are limitations and costs.
First, to be eligible for the conversion, your adjusted gross income in
the year of conversion must not exceed $100,000. In addition, you must pay
taxes on the accumulated value of the IRA (less any nondeductible
contributions you have made) when you make the conversion. There had been a
provision to allow for the taxes to be spread over four years, but that is no
longer available.
Be sure to consult your tax advisor if you believe converting makes sense.
Most professionals have software that can help with the analysis.
