Congress doesn’t do much right, it seems. But when it created individual retirement accounts (IRAs) in 1974, it gave Americans one of the most versatile investment vehicles ever conceived, and one that has become the fundamental building block for millions of retirement plans.
With a traditional IRA, you receive a tax break in the tax year in which you make a contribution, and you pay no taxes on the dividends, interest and capital gains that accumulate. You only pay taxes once you start to take distributions — in retirement. With a Roth IRA, you get no tax break in the year of the contribution, but you are able to remove the funds tax-free in retirement.
In 2014, you can contribute $5,500 to either type of IRA and $6,500 if you are age 50 or older.
Let me be clear: If you have income from a job or from a small business, you should have an IRA or a Roth IRA — or perhaps both, depending on your situation. There are no exceptions to that statement. None. So if you don’t already own an IRA or Roth IRA, opening at least one should be at the top of your to-do list in 2014.
Should I Open a Traditional IRA or a Roth IRA?
The answer to this question is going to depend primarily on three factors:
- Your age
- Your income
- Whether you have access to a 401k plan or comparable retirement plan at work
Age: When you fund a traditional IRA, Uncle Sam is giving you a tax break. But he still wants his money. Hence, we have “minimum required distributions.” When you reach the age of 70½, you are required to start withdrawing from your IRA account and to pay ordinary income taxes on the withdrawals.
These days, a lot of Americans continue to work well into their 70s, whether they need the money or not. Having a job, even if it is part-time, gives a sense of purpose (and frankly, something to do). If you are approaching or already over the age of 70, it makes sense to contribute to a Roth IRA, which has no distribution requirements, because you are not permitted to contribute to a traditional IRA after the age of 70½, and even if you could, it wouldn’t make sense as you would have to start withdrawing it immediately thereafter.
Income: Your ability to contribute to a Roth IRA gets phased out at higher incomes — and unfortunately, the income levels aren’t as high as you might think. You can contribute the full $5,500 to a Roth IRA if you are a single taxpayer with a modified adjusted gross income (MAGI) of less than $114,000. Contribution amounts start to phase out at MAGIs between $114,000 and $129,000, and if you make $129,000 or more, you cannot contribute at all.
Married couples can make a full contribution to a Roth IRA if their combined incomes are less than $181,000. Contribution limits for a Roth IRA phase out between $181,000 and $191,000, and at incomes of $191,000 or more, you cannot contribute at all.
So, if you are considered a high-income taxpayer, the Roth IRA is not an option for you.