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.
And when Congress created the Roth IRA in 1997, they took a great idea and made it even better.
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.
Let’s assume that your income makes you eligible for either a traditional or Roth IRA. There are still other income factors to consider.
Let’s say that you are married with two children and, due to the responsibilities of raising children, your spouse does not work. Let’s also assume you have a mortgage. If this describes you, chances are good that your dependent and home deductions put you in a very low tax bracket. In this case, the current-year tax deduction for a traditional IRA isn’t going to be worth much, and you’re going to be much better off with a Roth IRA.
But 10 to 15 years from now, your kids will have left the nest and your spouse has returned to work. You’re also paying less in mortgage interest because you’ve paid down a large chunk of your mortgage. You’re going to be in a much higher effective tax bracket. Taking an immediate deduction with a traditional IRA suddenly looks a lot better.
The questions you have to ask yourself are “What tax bracket am I in today?” and “What tax bracket do I expect to be in later?”
If your situation changes, no big deal. This is not monogamous marriage. You’re allowed to open multiple IRAs and to contribute to whichever one makes the most sense in a given tax year. Just make sure that you keep the total contribution under the $5,500 limit.
Retirement Accounts at Work: If you have access to a 401k or comparable retirement plan at work, your ability to deduct a traditional IRA contribution on your tax return may also be phased out. For a single taxpayer, you can take a full deduction at MAGI of $59,000 or less. Above that, your deduction is phased out, and no deduction is allowed at MAGI of $69,000 or more. For a married couple, the phaseout starts at MAGI over $95,000, and no deduction is allowed at MAGI of $115,000 or more.
This doesn’t mean that you can’t contribute, mind you. It simply means you can’t deduct the contribution. In this case, the Roth IRA clearly is going to be a better option for you.
But if you are unable to contribute to a Roth IRA due to, say, high income restrictions, the nondeductible traditional IRA is still a viable option. You just need to keep track of your basis so that you are taxed only on your earnings. (This is something you’d probably want to discuss with your accountant).
When would a nondeductible traditional IRA be appropriate? If you are aggressively saving for retirement, and you have already maxed out your company 401k plan, then tossing an additional $5,500 into an IRA can be a nice bonus.
Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.