4 Questions to Ask When Deciding to Fund a Traditional or Roth IRA
Originally posted on LinkedIn on March 2, 2020
It’s time once again for the annual, anxiety-inducing, age-old pilgrimage to your accountant’s office. Or, for the more intrepid, time to buy the software, brew a pot of coffee, block off some hours on your calendar and let your inner accountant loose. Whichever way you choose to do it, the time is now. It is time to file your income tax return.
Do you want to fund your IRA (Individual Retirement Account)?
At some time during the process, you may be presented with the option of funding an IRA, as this is one of only a few ways to alter your income tax liability for the previous tax year. In order to make an educated decision, it is important to know the differences between the two available options:
the Traditional IRA
the Roth IRA.
A traditional IRA is most often funded with “pre-tax” dollars. “Pre-tax” means you may receive an income tax deduction (*some results may vary) for the amount you contribute to the traditional IRA. The Roth IRA is paid with “after-tax” dollars. This means that you will not receive an income tax deduction when you contribute to the Roth. Both types allow the earning in the account to grow tax-free, so any interest, dividend, and other investment income accumulate tax-free as long as the funds remain in the IRA account.
The most notable difference between the 2 two types of IRAs is the taxability and timing of distributions from the accounts. Distributions from a traditional IRA are taxed when the funds are withdrawn (*some results may vary). Additionally, beginning at age 72, the IRS will require that you take annual minimum distributions from a traditional IRA. These distributions will be taxed at your marginal tax rate in the year taken. The tax owed on these distributions can come as a surprise to unsuspecting retirees. On the other hand, distributions from a Roth IRA are tax-free. Also, there is no requirement to take distributions from one’s own Roth IRA. So, is the income tax deduction on contributions to a traditional IRA starting to look a little less appealing?
How should you decide upon which IRA to fund?
The 4 questions you should address when it comes to deciding between funding a traditional or Roth IRA are as follows:
1) Are you eligible to contribute to either?
The two primary factors that determine eligibility are income and participation in an employer plan. Your accountant or tax software should be able to let you know if you are eligible to contribute to either.
2) Do you have available cash to contribute?
While these are once a year, use it or lose its limits, it is probably not worth it to borrow to fund these contributions. If you do not have the cash available, your decision is likely an easy one.
3) Do you anticipate that your marginal income tax rates will be higher in retirement than they are now?
Put another way, do you anticipate earning more money in retirement than you are earning now? If so, maybe it makes sense to pay the tax now at the lower rates and contribute to the Roth IRA.
4) Do you anticipate needing funds from your retirement accounts during your retirement?
As noted above, you will be required to take distributions from your IRA based upon IRS formulas. If you need more than the IRS mandated required minimum distribution amounts, you will be taxed on the larger amount. If you are taking distributions from a Roth IRA, these funds will be available to you tax-free, providing you with a flexible, cost-efficient way to fund any needs in retirement. Or if you do not need the Roth IRA funds in retirement, you can elect not to take any distributions, and transfer the entire Roth IRA balance to your heirs upon your passing.
Summary
The decision to fund a Traditional or Roth IRA can materially impact your income taxes and retirement. While the discussion above is a greatly oversimplified analysis of a complex tax and financial planning topic, it is important for taxpayers to know their options. Discuss your particular situation with your accountant and/or financial planner. Questions 3 and 4 are crystal ball-type questions, so having a comprehensive financial plan done by a Certified Financial Planner® may provide some insight into your financial future. While annual contribution amounts are not particularly large ($6,000 for 2019, plus an additional $1,000 if over age 50), if you factor in tax-free investment earnings and annual contributions over decades, these individual retirement accounts can become a significant portion of one’s retirement nest egg. You have until April 15th to decide for the 2019 tax year. Choose wisely, friends.
*Some restrictions apply – When dealing with tax issues, there are always multiple factors to consider. Consult a professional who understands your particular situation before making a decision.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, accounting, or financial planning advice. You should consult your own tax, legal, accounting, and financial planning advisors before engaging in any transaction.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.