The Many Benefits of the Roth IRA
Here is the difference:
When you use a traditional IRA, you can deduct your contribution up to $6,000 per year. It must come from labor income. If you are 50 or older, you can deduct an additional $1,000. When you reduce your taxable income by $6,000 and you’re in a 12% tax bracket, that means you’ve reduced your tax bill by $720. The higher your tax bracket, the more tax you save.
But there is more.
With the traditional IRA, your investment grows tax-free. You pay no current tax on the growth.
The keyword here is “deferred”. The day you start withdrawing money, you’ll start paying taxes on all withdrawals. The money is added to any income and you will pay taxes in your usual tax bracket. Make sure you don’t withdraw money until you’re 59½ or you’ll pay a 10% penalty on top of your regular tax.
You are required to receive minimum distributions at age 72.
Between the ages of 59.5 and 72, you can withdraw anything you want without penalty. You only have to pay ordinary income tax. After age 72, you can withdraw more than the required minimum distribution, but you cannot escape income tax.
How to evade taxes?
This is where the Roth IRA comes to your rescue. You don’t save tax when you contribute. There is no tax deduction. The money you contribute is after-tax money. After that, all of your growth and withdrawals are tax-free.
The way you escape taxes on a Roth IRA is to pay an “upfront fee.” This is the fee you pay upfront to enter. You might ask yourself, “Why should I pay such an entrance fee?” The answer is that the benefit of tax-free withdrawals can be much more advantageous than the entry fee.
The amount you can contribute to a Roth IRA is the same as a traditional IRA. It’s $6,000 plus $1,000 for those over 50. It must come from earned income. Income from stocks, bonds, social security, or inheritances is not considered income.
However, remember that the amount you can contribute to a Roth IRA is limited by certain income levels. For married couples filing jointly, the phase-out starts at $198,000. For singles and a single head of household, it starts at $125,000.
A key question for many remains: is converting your traditional IRA to a Roth IRA the right move for you?
Your decision depends on your current and future tax situation. You’re trying to figure out whether the tax rate you pay to use a Roth IRA today will be higher or lower than the rate you’ll pay on distributions when you withdraw them from your traditional IRA. Keep in mind that when you convert, you have to pay taxes on the amount you convert. You can also perform partial conversions.
Here are some questions to consider when trying to make a decision. They all relate to when you might be in a lower tax bracket.
- You expect to stop working or work part-time, which will result in lower income and possibly a lower tax bracket. These may be times when you would consider making a conversion.
- You plan to move to a state with lower or no income tax.
- You plan to move to a more expensive house with a lot more tax-deductible interest on a mortgage.
- You have a lot more deductible health expenses.
- You think that because of the high public debt, there will be an increase in income taxes.
- You are younger and starting a career with a lower income.
- You are retired and for at least a year you will have very little or no earned income. This should be before you take Social Security, which could put you in a higher bracket.
And ask yourself these questions:
What is my current tax situation? What will my future tax bracket be? Is it higher or lower than my current one? Will my annual income increase or decrease?
There are many detailed variables that cannot be handled in a single column. Keep in mind that this isn’t just a numbers game. It’s also a matter of personality and lifestyle. A good decision is based on a holistic approach. I recommend hiring a fee-based Certified Financial Planner who is trained to help you see the big picture.
Vern Hayden is a certified financial planner and the author of “Getting an Investing Game Plan”.
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