When it comes to retirement planning, I would argue that time in the market trumps timing, yet people don’t always invest when they can. Fortunately, the IRS has a provision for those procrastinators. You can make your IRA contributions until April 15th of the following year.
I believe one of the many reasons so many people wait to make retirement contributions is because they simply struggle with the decision, Roth or traditional.
Both IRAs allow people to contribute to retirement accounts. Contributions are limited, and eligibility is based on age, earned income, and availability to company-sponsored retirement plans. Couple that with the various tax implications. It’s no wonder that people are still confused.
Here are the basics to help you decide: Roth or Traditional
CONTRIBUTION LIMITS
The IRA allows the smallest annual contribution in the retirement account spectrum and is most beneficial when people do not have access to an employer-sponsored retirement plan. Both the Roth and traditional IRA share the same contribution limits. Contribution limits are set annually by the IRS and are currently limited to the lesser of $6,000 or your earned income. If you are over fifty, congratulations, the IRS allows what is known as the catch-up contribution. Catch-up contributions are currently limited to $1,000.
ELIGIBILITY AND DEDUCTIBILITY
Just because you want to contribute to an IRA doesn’t mean you can. First and foremost, you must have earned income to contribute. If you have earned income, you also must jump through a few more hoops to verify eligibility. Of course, Roth and traditional IRAs come with different eligibility rules.
In 2021 to be eligible for a full contribution to a Roth IRA, your MAGI (modified adjusted gross income) must be under $125,000 for a single filer and $198,000 for married filing joint filers. These income amounts indexed up in 2022, allowing a single filer with MAGI up to $129,000 and a married filer up to $204,000 to make a full contribution. Phaseout ranges allow for partial contributions. In 2021 phaseout limits for a single filer are capped at $140,000, while a married filer caps MAGI at $208,000. In 2022 those amounts are higher, at $144,000 and $214,000, respectively.
Traditional IRAs have their own set of eligibility and deductibility rules. Traditional IRAs also add one other consideration: employer-sponsored retirement plans for you and your spouse if you are married.
If you are eligible for contributions in an employer-sponsored retirement plan, your income limitations are more restrictive. Single filers, covered by an employer-sponsored plan making under $66,000 can make the full tax-deductible IRA contribution. Phaseout limits allow for partial contributions for income limits up to $76,000. The amounts for married filers covered under employer-sponsored plans increase to $105,000 for full deductibility, and phaseout ranges up to $125,000.
The IRS imposes less restrictive limitations if an employer-sponsored retirement plan covers only one spouse. Full deductibility is allowed for married filers making up to $198,000. Phaseout ranges allow for partial contributions for an income up to $208,000.
If you or your spouse cannot participate in an eligible employer-sponsored retirement plan, your deduction is allowed in full.
TAX CONSIDERATIONS
Both the Roth and traditional IRAs offer appealing tax benefits. The timing of the tax benefits is the main difference between the two. Knowing when you get your benefit can be a key consideration in deciding between the Roth and Traditional IRA.
Traditional IRAs are typically tax-deductible and lower your taxable income in the contribution year. The IRS is giving you a quick tax break. Your IRA grows tax-deferred and qualified distributions are taxed as ordinary income when withdrawn.
You don’t get your tax benefit so quickly with a Roth contribution. Your contribution will not give you a current tax deduction, but future qualified withdrawals are not taxed. Your Roth-IRA grows tax-deferred, and as a bonus, the gains are tax-free. Since you paid the tax bill upfront, you don’t owe the IRS at the back end when you take the money out. The tax benefits don’t end with you. Beneficiaries collect tax-free distributions too.
THE BOTTOM LINE: HOW TO DECIDE
So, is a bird in the hand worth two in the bush? Unfortunately, in finance, it seems there is never a straight answer. It always depends on your specific situation. The bottom line comes down to first determine your eligibility. Then estimate your tax bracket, both now, when you are contributing, and your estimated tax bracket when you or your beneficiary take distributions.
The idea is to pay the taxes at the lowest bracket. If you think your tax bracket is higher now than where it will be when you use the money, select the traditional IRA and take your tax deduction with your contribution. This is typically the case for high earners and people in the late stages of their careers.
If you believe your tax bracket is lower now than when you plan to withdraw funds or when your beneficiary takes funds, select the Roth, and push your savings into the future. For those that have unusually low earnings for some reason or are early in their career with high expected future earnings, the Roth may make the most sense.
The differences between a traditional and Roth IRA are often a source of frequent confusion. Yet it is an important decision, as it can lead to lowering one of life’s most significant expenses, taxes. If you need help sorting through your options and determining what would be the best fit for you, give us a call, we are happy to talk you through your options.
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