Traditional or Roth IRA: Which Way Should You Go?
Farm Business Management Update, February 1998
By David M. Kohl and Troy D. Wilson of the Department of Agricultural and Applied Economics, Virginia Tech
It's the time of year when you may be considering how you can invest extra cash to reduce your income taxes. If you have not taken a section 179 on your income taxes, contributed to a SEP or Keogh plan, or prepaid expenses, you may think that you are out of options. However, you still have until April 15 to file and contribute to an IRA. The question becomes whether you contribute to the traditional one or the new Roth IRA.
The traditional IRA allows you to make tax-deductible contributions under certain financial conditions. Contributions and earnings grow tax-free and may be withdrawn after reaching age 59-1/2. The distributions are then taxed as normal income at the tax rate that is applicable at the time of withdrawal. The new Roth IRA was created in 1997 by the Taxpayer Relief Act and allows eligible taxpayers to make after-tax contributions. Although the Roth IRA does not offer an initial tax break, contributions and earnings grow tax-free and are tax-free when they are withdrawn.
Are You Eligible for the Traditional IRA?
If you have earned income and are not covered by an employer-sponsored retirement plan, you may make deductible contributions to a traditional IRA up to $2,000 per year (or 100 percent of earned income if it is lower), regardless of the level of your income. If you are covered by a plan at work, such as a 401(k) or 403(b), you must meet the adjusted gross income limitations in order to make fully deductible contributions. For 1998, the limit for single filers is $30,000 and $50,000 for married people filing jointly. Under the new tax law, these limits increase each year until 2007. For married couples, if one spouse is covered by a retirement plan at work, the other can make deductible contributions up to $2,000 provided that their total adjusted gross income does not exceed $150,000. If you do not meet the income restrictions, you may still make non-deductible contributions that will increase and be tax-deferred.
Are You Eligible for the Roth IRA?
The eligibility requirements for the Roth IRA are much less stringent. For example, you are a beef farmer, married, and filing a joint income tax return. You and your spouse can each contribute up to $2,000 per year, if your joint adjusted gross income is $150,000 or less. If you are single, you may contribute up to $2,000 per year, if your adjusted gross income is $95,000 or less. If an exceptionally good year puts you over the limits, you can still make non-deductible contributions to the traditional IRA. Coverage under an employer-sponsored retirement does not impact your eligibility for a Roth IRA.
What About Withdrawals?
All withdrawals are penalty-free after age 59-1/2 for both types of IRAs, with an additional stipulation that the account has been established for more than five years in the case of the Roth. In the past, exemptions to the 10 percent penalty for early withdrawals were allowed in the case of death or disability of the owner, for extraordinary medical expenses, and for health insurance while unemployed for more than 12 weeks. The new law provides two additional exceptions: (1) for the purchase of a first home ($10,000 lifetime limit), and (2) qualified educational expenses.
Can You Roll Over Your Traditional IRA into a Roth IRA?
If your adjusted gross income is less than $100,000, you may roll over your traditional IRA into a Roth IRA. No penalty is applicable, but you'll have to pay taxes on the rollover. In 1998 only, owners of the traditional IRA will pay the taxes on the roll over across a four-year period and can immediately withdraw the funds without penalty. You may not roll over funds from an employer-sponsored plan such as a 401(k) or 403(b) directly into a Roth IRA.
Which Way Do You Go?
If you are a producer who needs a tax deduction because you are in a high tax bracket, you may want to follow the traditional IRA route. A $2,000 IRA contribution nets a $560 tax savings if you are in a 28 percent tax-bracket, and the money grows and compounds tax-free. If you expect to be in a lower tax bracket in retirement than you are currently, again the traditional IRA might benefit you. Total contributions, return on the IRA investment, and future tax policy changes need to be analyzed as you make the decision.
Unlike the traditional IRA, the owner of a Roth account is not required to take minimum distributions after age 70-1/2. Additionally, when you are older with earned income, you can continue to contribute to a Roth IRA after reaching 70-1/2, something not allowed by the traditional IRA. Bottom line, if you plan to continue to earn income after age 70-1/2 or if you have significant other sources of retirement income, the Roth may be the better choice for you.
A Look at the Numbers!
In comparing the Roth IRA with a traditional tax deductible IRA, you must factor in the different tax ramifications. If you are in a 28 percent tax bracket, you would have to have $2,778 in pre-tax income in order to contribute a net of $2,000 to the Roth IRA ($2,778 x 28% = $778 in taxes). The following comparison is based on $2,778 in earned income or wages.
|Traditional IRA||Roth IRA|
|Tax deductible contribution||($2,000)||$0|
|Tax rate of 28%||($218)||($778)|
|Roth IRA contribution||$0||$2,000|
The traditional IRA reduces taxable income to $778 and will result in $218 in federal income taxes, leading to an after-tax income of $560. In this case, you have $2,000 in a tax-deferred account, plus $560 to invest in a taxable account outside of the IRA. Alternatively, you could have $2,000 after taxes to invest in a Roth IRA and pay $778 in federal income taxes.
What happens over time?
Initially, the traditional IRA appears superior because of the up-front tax break. However, looking at your initial investment growth after 20 years, assuming that you earn an 8 percent return and the tax rate does not change, the picture may change.
|Traditional IRA||Roth IRA|
|Taxes on IRA distribution at 28%||($2,613)||$0|
|Net IRA distribution||$6,719||$9,332|
|Net funds after 20 years||$8,435||$9,332|
As long as the tax rate in effect when the deduction on the traditional IRA is taken is not significantly higher than when withdrawals are taken, the Roth IRA is the better choice. The Roth becomes even more beneficial if you believe you will be in a higher tax bracket during the retirement years than at the present.
Look at an alternative situation in which tax rates will be lower upon withdrawal than at the present.
|Traditional IRA||Roth IRA|
|Taxes on IRA distribution at 15%||($1,400)||$0|
|Net IRA distribution||$7,932||$9,332|
|Net funds after 20 years||$9,648||$9,332|
If your tax rate is 28 percent when the initial investment is made and then falls to 15 percent during retirement, the traditional IRA results in higher after-tax wealth.
Finally, if tax rates stay the same, and you assume that your contribution to a Roth IRA is equivalent to $2,000 or less of pretax income, very little difference between the results of the two IRA programs occurs.
Some of you may be unclear as to what options are available for investing the funds in your IRA and what type of returns you can expect. This topic could warrant an entire discussion in itself. However, depending on your risk preference and investment horizon, you may invest in something as conservative as CDs or as risky as aggressive mutual funds.
The tax savings from investing in either type of IRA are substantial. However, when searching for a financial institution to set up your IRA, be careful of fees. If a $2,000 IRA contribution earns a 10 percent return, or $200, a $30 fee would erode your net return to $170 or 8.5 percent. Be aware of advisory fees as well as back loaded fees, if you decide to take your money to a brokerage firm.
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