Category: Retirement Planning

The “Traditional” IRA and The “Roth” IRA

If you’re like me, you relish those moments when you can retreat to that one place in the house that everyone knows to be yours, enjoy a cup of jo, and just reflect on the attributes of the Traditional IRA and its cousin, the Roth IRA. Who am I kidding, that’s nothing like me… and there’s no place in my house that’s recognized as just mine. And if this indeed does describe you, then allow me save you a little time. Here’s a comparison of the two at a glance:

Any age limitations you should know about?

Roth IRA: You can contribute to them at any age.
Traditional IRA: You must be under age 70½ to contribute to one.

Could your income level affect your contribution eligibility?

With a Roth IRA, the amount could be reduced, and possibly eliminated, based on your modified adjusted gross income (MAGI).
Traditional IRAs have no income level restrictions, but they do have deductibility restrictions which we’ll cover later.

And for both, you must have earned income as defined by the IRS in order to make a contribution at all.

Taxable earned income includes:
• Wages, salaries, tips, and other taxable employee pay;
• Union strike benefits;
• Long-term disability benefits received prior to minimum retirement age;
• Net earnings from self-employment if:
o You own or operate a business or a farm or
o You are a minister or member of a religious order
o You are a statutory employee and have income. Statutory workers are those who meet the independent contractor rules    as employees for employment tax purposes by statute.

Examples of income that are not earned income:
• Pay received for work while an inmate in a penal institution
• Interest and dividends
• Retirement income
• Social security
• Unemployment benefits
• Alimony
• Child support

Are there any contribution limits you should know about?
For the 2014 tax year for both the Roth and Traditional IRA:

If you’re under age 50, you can contribute up to $5,500.
If you’re age 50 or older, or will be by the end of the year, you can contribute up to $6,500.

Limits could be lower as the amount of your contribution can’t exceed the amount of income you earned that year.

Can you claim your contribution as a deduction at tax time?

Roth IRA: Contributions cannot be deducted.
Traditional IRA: Some, and possibly all of these contributions can be claimed as an IRA deduction. The deductible amount could be reduced or eliminated by the following factors: whether you or your spouse are covered by a retirement plan at work, the amount of your modified adjusted gross income, and your filing status.

How about deadlines for making a contribution?

For both, the deadline is typically April 15 of the following year.

What if you want to take money out of your IRA?

Roth IRA: You won’t pay taxes on the withdrawals of your contributions. And you won’t pay taxes on withdrawals of your earnings as long as you take them after you’ve reached age 59½ and you’ve met the 5-year holding period requirement.

Our friends at Vanguard detail the 5-year holding period below:
The 5-year holding period for Roth IRAs starts on the earlier of the date you:
• First contributed directly to the IRA.
• Rolled over a Roth 401(k) or Roth 403(b) to the Roth IRA.
• Converted a traditional IRA to the Roth IRA.
If you’re under age 59½ and you have one Roth IRA that holds proceeds from multiple conversions, you’re required to keep track of the 5-year holding period for each conversion separately.

Traditional IRA: You’ll pay ordinary income tax on withdrawals of all earnings and on any contributions you originally deducted on your taxes.

Is there a penalty for withdrawals taken before age 59½?

Roth IRA: On earnings, yes. On contributions, no. No penalties on withdrawals of Roth contributions – just the earnings.
Traditional IRA: There’s a 10% federal penalty tax on withdrawals of both contributions and earnings.

Our friends at Vanguard have listed the exceptions to the penalty tax. See below if any apply to you:

Distributions received before you’re age 59½ may not be subject to the 10% federal penalty tax if they’re:
• Due to your disability or death.
• Distributed to a reservist who was ordered or called to active duty after September 11, 2001, for more than 179 days.

Or if they’re to be used for:
• A first-time home purchase (lifetime maximum: $10,000).
• Post secondary education expenses.
• Substantially equal periodic payments taken under IRS guidelines.
• Certain unreimbursed medical expenses.
• An IRS levy on the IRA.
• Health insurance premiums (after you’ve received at least 12 consecutive weeks of unemployment compensation).

Will you have to take RMDs? (Required Minimum Distributions)

Roth IRA: Nope. They don’t exist in the Roth world unless we’re talking about an inherited Roth IRA. If you’ve inherited a Roth from a non-spouse, you must take a distribution no later than 12/31 of the year after the year of death.
Traditional IRA: Yes, you must take your first RMD by April 1 of the year following the year you reach age 70½.

Most of my clients hold Traditional or Roth IRAs – and many of them hold both . And the reasons for being in one over the other would be a great blog topic. I’ll get on that here shortly. Meanwhile, should you have specific questions about them, please don’t hesitate to give us a call.  Bottom line:  2 great flavors, 1 great retirement instrument.

Investment advisory services offered through CapSouth Partners, an independent registered Investment Advisor. CapSouth Partners does not render legal, accounting, or tax advice. Please consult your legal or tax advisor before taking any action that may have tax or legal consequences.

The type of compensation received by retirement plan advisors is coming under Department of Labor scrutiny.

DOL Assistant Secretary Phyllis Borzi’s April 1, 2013 newsletter reminds plan sponsors that hidden fees and financial conflicts of interest may compromise advice they receive. She states that conflicted advice that puts the interest of the financial advisor over those of the client’s contribute to lower account balances at retirement. It is often difficult to determine whether an advisor is operating as a sales person or as a trusted investment advisor (see: http://www.dol.gov/ebsa/newsletter/).

When I was growing up, it seemed as if my parents had this hidden and ever-expanding list of things I was too young to do.  On the list: ride my bike to school, have and/or shoot a BB gun, drive the car (peculiar, as I was 18 at the time), drink coffee, and put more than three mothballs in my mouth at any one time. There were others on this list that were SO prohibited they were never, ever discussed. Yet, I survived. But today, sadly, it seems like culture offers no “prohibited list” whatsoever.  It calls to our kids like Sirens to sailors to “start now, or you could miss out!”

As a father of four boys, I have a list as well.

But I’ll join culture’s call on one topic – saving for retirement. “Why start now?” you ask. Because one day you will retire. Because the government didn’t/shouldn’t take you to raise. Because living expenses don’t cease when the pay periods do. Most importantly – it’s your retirement, it’s your responsibility, and you’ll want to be ready for it. Enter:  The Rule of 72.

The Rule of 72:  A rule stating that in order to find the number of years required to double your money at a given interest rate, you divide the rate of return into 72. The result is the approximate number of years that it will take for your investment to double. So, let’s say you’re 30 years old and have $25,000 in your 401(k). Let’s also assume you receive an 8% annual return on your investment. Given the formula above, your money should double every 9 years. See the illustration below:

Age                        Balance

30                           $25,000
39                           $50,000
48                           $100,000
57                           $200,000
66                           $400,000

Granted, there are assumptions being made with respect to an 8% return year after year. But let’s look at it another way. Let’s say you opted for the Ford F150 with that $25,000.00, rather than having it invested in your 401(k) or IRA.  Are you even driving that truck 9 years later? If so, a quick value comparison with Kelly Blue Book and your retirement account will speak volumes. This is a $25,000 decision that could cost you $375,000. Listen closely and you’ll hear the sound of the Sirens beckoning…this time, however, it’s okay to listen.

Start saving.