IRAs and the Fiscal Cliff

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Before January 1, 1998 if someone wanted to open an IRA account there was only one option available: the Traditional IRA. After January 1, 1998 IRA investors had a decision to make: Traditional or Roth?

During my early years in the financial services industry, the Traditional IRA was the only game in town, so that is what I knew and became comfortable with. I did not fall in love with the Roth IRA when it became available, and must admit I have had a Traditional IRA bias. That bias has diminished over the years to the point that I can say it is now gone. In fact, as I make my financial plans and set my financial goals for 2013, opening a Roth IRA is on my “to-do” list. To understand why, let’s first take a look at the two different types of IRAs. 

Traditional IRA

*Tax-deferred earnings — Earnings generated on Traditional IRA contributions are tax-deferred. Financial organizations do not report IRA earnings to the IRS. IRA owners do not include earnings from Traditional IRAs in income until the year they take a distribution.

*Tax deduction — Congress created income tax deductions for IRA contributions to encourage taxpayers to save for retirement. Traditional IRA contributions may or may not be deductible, so make sure you talk with a tax advisor.

Roth IRA

*Tax-deferred earnings — Earnings generated on Roth IRA contributions are tax-deferred. Financial organizations do not report Roth IRA earnings to the IRS.

*Tax-free earnings — Earnings are withdrawn from a Roth IRA tax-free if the IRA owner has a qualified distribution (5 year period and qualified reason).

What does this mean?

Essentially, this means that a Traditional IRA provides a tax deduction in the years you contribute to your IRA. However, the money you withdraw from your Traditional IRA is taxed. While the Roth IRA doesn’t provide a tax deduction when you contribute, qualified distributions from your Roth IRA are not taxed.

Our government’s current financial situation indicates that higher taxes may be on the horizon. Some have said that it took 50 years to get into the predicament we are in, and that it may take 50 years for us to get out of it. This is why I’m considering a Roth IRA in 2013: if taxes rise and remain high years from now, I can save a lot of money paying taxes now at a lower tax rate and not paying taxes later when tax rates climb.

Let’s look at a simple scenario

You are currently in the 25% federal income tax bracket and are considering making a $1000 contribution from current income to an IRA account. If you choose a Traditional IRA, that contribution may provide a current year tax deduction (25%x$1000=$250). The Roth IRA does not offer a current year tax deduction. Let’s assume the $1000 contribution grows to $10,000 over your working years and you are now retired and ready to withdraw the $10,000. Let’s also assume that while you have remained in the same income bracket, the tax rate has increased from 25% to 28%.

A $10,000 distribution from a Traditional IRA would be taxed at 28% ($10,000×28%=$2800 tax) leaving you with $7200 in your pocket. A $10,000 distribution from a Roth IRA is tax-free if the owner takes a qualified distribution, meaning that the entire withdrawal is spendable income.

In this scenario, the tax deduction of a Traditional IRA would save you $250 at the time of the contribution; a Roth IRA would save you $2,800 at the time of distribution.

So which one is right for you?

This was just one very simple example. Generally speaking, if you need a tax deduction then consider a Traditional IRA; if you already have significant tax deductions (like children and home mortgage interest) and/or want to maximize income during retirement, then a Roth IRA may be a great choice.

Either way, you should closely review your financial situation and retirement plans before deciding which IRA to go with. You can use our Basic Comparison Calculator to get started and if you have any questions, you can leave a comment below!

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