Pioneer Wealth Management Group is a fee-only financial planning firm in Dallas and Austin, TX. Milad Taghehchian, a Certified Financial Planner based in Austin, TX, offered to write for our blog this week.
Contributing to your IRA is one of the most important things you can do for your future. But many people don’t know which one to contribute to, or how they can benefit from choosing between the two options. We will outline the differences and run through a quick comparison of the benefits of each one.
The Difference
The bottom line is this: do you want to defer your tax burden, or face it today? If you meet the criteria, the IRS has provisions that allow you to deduct your contributions to your traditional IRAs from your taxable income – i.e., you “earn” less this year. With traditional IRAs, however, you have to pay taxes on that money when you retire and begin taking it out of that account.
With ROTHs, the contributions do not get deducted from your taxable income. Instead, you pay taxes on that money today. This option makes sense for people that do not earn that much today – they are in low tax brackets and will not be taxed as heavily. As they begin earning more, it might make more sense to put the money in a traditional IRA and defer the taxes until they retire, at which point they’ll likely be in a lower tax bracket. The key here is to try to pay taxes when they’ll be lowest – but timing this can be difficult, as future tax rates are essentially unpredictable. For all we know, they’ll just keep increasing!
Early Withdrawals
Before age 59-1/2, the IRS will charge you 10% to withdraw money from your IRAs. However, the ROTH offers more advantages for people who need to withdraw early. If the money has been in your IRA for at least 5 years, a ROTH will let you take out the principal contributions (not what you’ve earned in interest) without charging you a penalty. Withdrawing the earnings would incur a 10% penalty, however. Remember that a ROTH charges taxes upfront and therefore would not incur any tax liabilities if it’s withdrawn early.
There exist some circumstances under which you can make early withdrawals from both types of IRAs without incurring any penalties. These include paying for higher education expenses and buying a home for the first time, among others. Keep in mind, however, that a traditional IRA will incur taxes at the time of withdrawal – whether early or not!
Required Minimum Distributions
Once you turn 70-1/2, traditional IRAs require that you begin withdrawing money from your account. On the other hand, ROTHs do not have these requirements and therefore allow you to grow your money for as long as you want. This is a better option for people that don’t need the money until later on in retirement, as they’ll be able to grow it for much longer than someone who has to begin making withdrawals at age 70.
Bottom Line
Both types of IRA accounts offer different advantages for different people. In deciding where to put your money, you should consider your future earnings potential and retirement needs. Finally, many people decide to use a mix of both accounts.
If you’re a Texas resident in the Austin or Dallas area, we recommend you visit a fellow fee-only financial planning firm. Check out pioneerwealth.com or call Pioneer Wealth Management Group at 512-334-6800.
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If a taxpayer cetnorvs his or her IRA and then dies, the amount of conversion income not previously reported, will be included in the decedent’s final tax return. However an exception is made if the Roth IRA is inherited by the spouse. If the spouse so elects, the spouse can continue to report the conversion income on the same schedule as the decedent would have. This election cannot be made or rescinded after the due date of the spouse’s tax return for the year of the decedent’s death. Roth IRA Conversion AdvantagesThe 2010 Roth IRA conversion may prove beneficial for a number of investors. Assuming tax rates do not drop significantly in the future, the conversion makes a lot of sense. The main advantage of the Roth IRA is its very favorable tax treatment when it comes to distributions. These qualified distributions are tax free, of course, but there are some other Roth IRA conversion benefits:There is no Required Minimum Distribution (RMD) during your lifetime.An IRA conversion to Roth IRA will require the payment of any necessary taxes, but will assist in shrinking your taxable estate. This provides you the opportunity to bequeath the select Roth funds tax free to your heirs.You can choose to not pay taxes on the conversion in 2010 and postpone the taxes in equal shares until 2011 and 2012. Normally, you’d be required to pay all taxes in the year of the conversion.Obviously, the primary advantage of the Roth IRA is its tax-free nature. Having investment earnings completely free from taxation is alluring, but the two following Roth IRA rules must be met in order to receive tax-free distributions:1. The withdrawal takes place at least five years after the initial Roth contribution, and2. One of the following applies:a. The Roth IRA owner is 59 bd or olderb. Disability (permanent)c. Death of participantd. First-time home purchase ($10,000 lifetime cap)