Traditional IRA vs Roth IRA

So, here’s the question…which type of Individual Retirement Account (IRA) is right for me? Should I make a contribution to a traditional IRA or a Roth IRA?

Before we can answer that question we have to answer some others first. Are you eligible to make an IRA contribution? If so, which type of IRA are you eligible for this year? Let’s get to the answers….

Earned Income Limitation

In order to make a contribution to either type of IRA you must have earned income. The amount of your IRA contribution is limited to the amount of earned income that you report on your tax return for the year. If you do not have any earned income this year we don’t have to go any further – you are not eligible. But see the note below for sharing earned income between spouses.

Age Limitations

Next we move on to the question we should only ask of men….How old are you? For the right tax answer we will have to ask the women as well. There is no lower age limit for making a contribution to an IRA. However, if you have reached the age of 70 ½ by the close of the year, you are not eligible to make a contribution to a traditional IRA. This is not the case with a Roth IRA. Roth IRA contributions can be made by individuals of any age.

Covered Plan and Income Limitations

Now we will have to look at whether you or your spouse is covered by a retirement plan at work. If neither of you is covered, then the amount of your income is irrelevant for a traditional IRA. However, if one or both of your is covered then we need to start looking at your income to see if your modified adjusted gross income (MAGI) is going to limit the amount that you can claim as a deduction for a traditional IRA. Below is a table showing the phase-out range for traditional IRA deductions based upon filing status and MAGI.

For Roth IRA’s there is no consideration of whether you are covered by a retirement plan at work. However there is a phase-out range for each filing status summarized below.

Married filing joint phase-out range: $167,000 – $177,000

Married filing separate phase-out range: $0 – $10,000

Single phase-out range: $105,000 – $120,000

Now that we know some of the limits, let’s look at how much you can contribute (and deduct for traditional IRA’s). For 2010 the maximum amount that an individual can contribute to an IRA is $5,000. If you are fortunate enough to have attained age 50 as of 12/31/10 then you are able to contribute an additional $1,000.

Sharing earned income between spouses.

If your spouse does not have enough earned income to claim their full IRA deduction or make the full contribution to a Roth IRA, you can share. The earned income limitation on a joint tax return can be shared between the two spouses to allow both spouses to claim up to the full amount of an otherwise allowable IRA deduction. The same applies for Roth IRA’s. Spouses can share earned income to allow each to be able to contribute up to the maximum amount otherwise allowable.

Above are the basic limitations: Earned Income, Age, MAGI and Other Plan Coverage. Now let’s consider the tax consequences of each type of IRA.

Marginal Tax Bracket

If you are in a high tax bracket (say 33% federal and 9.3% state) a traditional IRA deduction of $5,000 will save $2,115 in taxes on last year’s tax return. In today’s tax world this would probably be a simple decision – make a contribution to a traditional IRA. If you are in a low tax bracket (say 10% federal and 2% state) a traditional IRA deduction of $5,000 will save you $600. Unless you anticipate not having any taxable income in the future, a Roth IRA makes the most sense.

Impact of Other Tax Factors

In addition to knowing your tax bracket, you need to consider the impact on the rest of your tax return for a deduction of an IRA. If you have social security benefits that are being taxed because you have exceeded the base amount for your filing status, the reduction in your AGI could also reduce the taxable amount of your social security benefits. If you have passive activity losses in active participation real estate rentals that are being suspended because your income is in the phase-out range for your filing status, an IRA deduction could be effectively increased by 50%. Any decrease in your AGI could allow a corresponding 50% of the passive losses being suspended in the phase-out range.

Phase-outs aren’t the only considerations. Certain deductions and credits have “cliffs.” For example, the deduction for higher education expenses has a cliff at $160,000 income. If your IRA deduction will bring you below this cliff it will increase the benefit of the deduction.

Tax-Free Income for Life

The most popular characteristic of the Roth IRA is that the earnings are never taxable when they are withdrawn at least five years after the account is opened. The trade-off for this treatment is that the contributions to the Roth IRA are never deductible.

You’re Never Too Old

Traditional IRA’s have an age limitation – no contributions are allowed after the year in which you turn 70 ½. Roth IRA’s do not have the age limitation. You can make contributions to your Roth IRA at any age.

The answer to the question, “Which type of IRA is right for me?” cannot be made without careful consideration of several factors. So when you are ready to ask the question, your tax professionals at Seid & Company, CPAs are ready to find the right answer for you.