Roth IRA or Traditional IRA-Which is Best?
First, you should determine if you are qualified to contribute to either. You may contribute to either traditional or Roth IRAs only to the extent you have earned income includible in gross income. The maximum contribution for a taxpayer and the taxpayer’s spouse is $4,000 each. Individuals who are at least age 50 will be able to make an additional contribution of $500 ($1,000 for 2006). You have until April 17th, 2006 to make an IRA contribution for the 2005 tax year. You must be less than age 70 ½ to purchase a traditional IRA.
In addition to the $4,000 limit mentioned above, contributions to traditional IRAs can be further limited when the individual (or spouse) is an active participant in a retirement plan maintained by an employer. The maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is an active participant, is phased out when modified adjusted gross income is between $150,000 and $160,000.
The maximum deduction for an individual who is an active participant in a retirement plan is phased out when modified adjusted gross income is between ($50,000 to $60,000 for single and head of household; $0 to $10,000 for married filing separate).
When both spouses are active participants in an employer sponsored retirement plan, tax deductible contributions are phased out when modified adjusted gross income is between $70,000 and $80,000. If your tax deduction is limited by the active participation rules, look to the Roth rules.
Roth IRAs are not subject to the active participation rules. However, contributions to Roth IRAs are phased out when income exceeds the thresholds. Contributions made by single filers are phased out when modified adjusted gross income is between $95,000 and $110,000, and for joint filers with modified adjusted gross income between $150,000 and $160,000, and for married filing separately with modified adjusted gross income between 0 and $10,000.
Roth and traditional IRAs also have different distribution rules, which goes beyond the scope of this article.
So if you qualify for both traditional and Roth, and you are not concerned with the different distribution rules, what is best?
With traditional IRAs, you get an immediate tax deduction. Tax on your contribution is deferred until final distribution. Also, all earnings inside your traditional IRA grow tax deferred. Roth IRAs offer no immediate deduction. However, all earnings inside your Roth IRA grow tax free, not tax deferred.
Therefore, you must consider what tax bracket you are in now and what tax bracket you will be in when you receive the distributions. If you are in the 10 or 15 percent tax brackets, Roth may be a good choice. Based on a $4,000 contribution, you are bypassing immediate tax reduction of $400 to $600 in exchange for a lifetime of tax free accumulation on your $4,000 investment. This option looks even stronger if you expect to be in a higher tax bracket when you finally distribute your accumulation.
On the other hand, if you are in the 35 percent tax bracket, a Roth election means bypassing $1,400 immediate tax reduction (on a $4,000 contribution). If you expect to be in a lower tax bracket when you finally distribute your investment, as many retirees are, it makes sense to contribute to a traditional IRA and get an immediate tax break.