Distinguishing traditional IRAs from Roths
There are two basic types of IRAs: the traditional IRA and the Roth IRA. With either one, the deadline for contributions for the 2017 tax year is April 17, 2018. There are no extensions for making IRA contributions for 2017, even if you obtain an extension for filing your return.
It is important to know the similarities and distinctions of the two types of IRAs. For starters, the annual limit for contributions to either IRA for the 2017 tax year is $5,500. (It remains the same in 2018.) Plus, you can add another $1,000 if you are age 50 or older. There is no current tax on the contributions’ earnings within an account.
Generally, you can contribute to an IRA if you receive earnings or other compensation from a job. However, the ability to contribute to a Roth IRA is limited or eliminated for certain high-income taxpayers. Here are the other main differences to keep in mind:
1. Traditional IRAs: Contributions may be wholly or partially deductible. But deductions are phased out if your modified adjusted gross income (MAGI) exceeds a specified level and you (or your spouse, if you are married) are an active participant in an employer-sponsored retirement plan. Therefore, for many individuals, no part of the contribution to a traditional IRA is tax-deductible.
When you receive distributions from a traditional IRA, you are taxed at ordinary income tax rates on the portion representing deductible contributions and earnings. In addition, you will have to pay a 10% penalty tax on withdrawals made before age 59½ unless one of the special tax law exceptions applies.
2. Roth IRAs: Unlike contributions to a traditional IRA, contributions to a Roth are never tax-deductible, regardless of your MAGI. But there is a potential payoff on the back end that you cannot realize with a traditional IRA: Qualified distributions from a Roth in existence for at least five years are 100% tax-free. For this purpose, qualified distributions include withdrawals made after age 59½, those made on account of death or disability, or those used to pay qualified first-time homebuyer expenses (up to a lifetime limit of $10,000).
Other distributions are taxed as ordinary income under “ordering rules.” Contributions are treated as coming out first, followed by conversion and rollover amounts and then earnings. Thus, even if you do not receive qualified distributions, part or all of the payout may be tax-free.
Due to the lure of tax-free distributions, you might consider converting some or all of the funds in your traditional IRA to a Roth IRA. But be aware that the conversion itself is taxable at ordinary income rates, just like a withdrawal. Also, if you must use funds being transferred to pay the resulting conversion tax, it will dilute some of the tax benefit.
Which type of IRA is best for you? It depends on a number of variables, such as your current and future expected tax rates and your personal circumstances. Rely on your professional advisers to provide guidance.
For more information on the above article or other financial planning services contact Don Chastain, CPA at (334) 887-7022 or by leaving us a message below.
