As you plan for your retirement you may wonder whether you should choose to go with a Traditional or Roth IRA. Both accounts have their perks but choosing which one is best for you is the question.
Many are familiar with the Traditional IRA because it has been around since 1974. Traditional IRA’s allow pretax funds to be contributed into an IRA. For 2022 a maximum of $6,000 can be contributed (an additional $1,000 if you are over the age of 50). These funds and gains can be deferred until the contributor retires and begins to withdraw at 59 ½ or age 72.
Roth IRA accounts are newer than the Traditional IRA’s, founded in 1997 and have different rules to them. A Roth IRA allows for after tax funds to be contributed into the IRA. For 2022 a maximum of $6,000 can be contributed (an additional $1,000 if you are over the age of 50). The basis and gains will not be subject to tax upon withdraw for contributors upon retirement. Roth IRA accounts are not subject to a required minimum distribution. A Required minimum distribution or RMD, must be taken out at age 72 ½ each year. If you do not withdraw the required minimum you are subject to paying penalty fee. This RMD is only required for Traditional IRA’s, this does not apply to Roth IRA’s.
Now that we know the differences between the two accounts, determining which account is right for you is the next step. When determining which account is best for you consider your age, pay, and tax bracket. Each of these plays an important role in deciding which is right for you. In some cases you might consider using both accounts, we’ll get to that later. Roth IRA accounts however are much more attractive to younger contributors because they are most likely in a lower tax bracket. This means that the money contributed to the Roth IRA is taxed at a lower rate. The reason why this method is encouraged at a young age is because these funds can grow tax free until you decide to withdraw the funds. The downside is you don’t get a tax deduction and have to pay full taxes on dollar contributions to the Roth IRA.
Traditional IRA accounts on the other hand can be more beneficial as you earn more through your career. Traditional accounts allow for pretax dollars to be contributed tax deferred until you decide to withdraw the funds. However you are subject to taxes on gains and contributions when you go to withdraw. The good thing is you will likely be retired by the time you decide to withdraw from your Traditional IRA and you could be in a much lower tax bracket. Meaning you will pay less in taxes on your withdraw. The next good thing about Traditional IRA accounts is that you are eligible for a tax deduction each year. As long as you are under the phase out range you are able to deduct your full contribution on your taxes. We will learn later how the phase out range works.
As mentioned earlier you might be consider utilizing both a Roth and Traditional IRA, here’s why. For example: If you are married filing joint and decide to contribute to a Traditional IRA you will need to consider what your modified AGI is. Modified Adjusted Gross Income or Modified AGI is your gross income after certain deductions. If your modified AGI is under $204,000 you are able to take the full $6,000 tax deduction. However if your modified AGI is between $204,000 and $214,000 you are in the phase out range. The phase out range is a set income range that the IRS decides that you are only able to deduct a certain amount. The closer you get to $214,000 the less you can deduct. This is where the Roth IRA comes into play. If you in the phase out range you will likely be able to deduct some of your Traditional contributions. The rest of the contribution will not be tax deductible. This is why you would want to contribute the nondeductible portion to a Roth account. Reason being is that you wont get a deduction for your Traditional IRA if you contribute the funds, so the best option is to allow after tax funds to grow in a Roth IRA.
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