American workers are increasingly turning to individual retirement accounts to close the gap between the amount of income they're likely to need during retirement and what they're likely to receive from Social Security. The reason is that IRAs offer tax advantages that can substantially enhance savers' retirement funds. Traditional IRAs allow you to take a tax deduction today but require that you pay income tax on withdrawals in retirement. That's the opposite of a Roth IRA, which taxes your contribution during the year you make it but allows you to take tax-free withdrawals.
Here are three problems with traditional IRAs that could make the Roth IRA a more sensible option for you
1. Income limits on deductibility
Making too much money is a good problem to have, but not if you hope to capture the up-front income tax deduction offered by a traditional IRA.
If you're single or married and you (and your spouse) aren't covered by a retirement plan through work, you can take the full tax deduction on a traditional IRA contribution regardless of how much money you make.
However, if you are single and earn more than $70,000 per year or are married and earn more than $116,000, and you are covered by a retirement plan at work, you won't be able to claim a tax deduction for a contribution to a traditional IRA made in 2014. If you are single and earn more than $60,000 or are married and earn more than $96,000, you'll only get a partial tax deduction on your 2014 traditional IRA contribution.
Additionally, if you're married and don't have a retirement plan through work, but your spouse does, then traditional IRA deductions begin phasing out at $181,000 and are fully eliminated above $191,000.
If you're planning your traditional IRA contributions for 2015, the income limits for deductibility adjust slightly upward. If you're covered by a retirement plan at work, deductions are eliminated at $71,000 if you're single or $118,000 if you're married. If you're married and not covered by a plan through work, but your spouse is, deductibility is eliminated above $193,000.
If your taxable income exceeds these traditional IRA limits, you might be able to use a Roth IRA instead, but only if your income is below the Roth IRA's own contribution limits. The ability to contribute to a Roth IRA begins phasing out for single filers with taxable income of $114,000 and married couples with taxable income of $181,000. If your income is above the Roth IRA income limit, you can still contribute to a traditional IRA, but you won't get a tax deduction.
2. Tax risk in retirement
Because traditional IRA withdrawals are taxed in retirement, a traditional IRA might not make the most sense if you expect your income tax rate to be higher during retirement than it is while you're working.
If you're married and your taxable income is between $18,151 and $73,800 in 2014, your tax rate is 15%. If you earn any more than that, your income tax rate jumps to 25% or more. Therefore if you expect to build up a substantial nest egg and be pushed into a higher tax bracket in retirement, then you might be in for an unpleasant surprise at tax time, and you might consider contributing to a Roth IRA instead.
3. Legacy planning shortcomings
Traditional IRAs require you to begin withdrawing funds when you reach age 70-1/2. That means regardless of your financial situation, you will have to start pulling money out of your traditional IRA and paying taxes on it at some point during your lifetime.
If you're financially secure in retirement, being forced to withdraw money from your traditional IRA -- and pay more income tax to the IRS -- isn't likely to make you happy. And there's yet another drawback: Withdrawals will reduce the amount of money in your IRA and, thereby, the potential for that money to continue growing on a tax-deferred basis for your heirs. Granted, you could invest that after-tax amount in another account, such as a Roth IRA, but unless you compensate for the money you spent to pay taxes on your withdrawal, the investment in the Roth and its corresponding growth will likely lead to a smaller balance to pass along to your beneficiaries. In this scenario, it would likely be a far simpler strategy to invest in a Roth IRA in the first place.
There's a lot to consider
Choosing between a traditional IRA and a Roth IRA is difficult, and what works best for one person will probably not work best for another. The biggest difference between these two is when you want to enjoy the respective tax advantages they offer. Regardless, if your tax situation is complicated or you're unsure which choice is best, sitting down with a tax professional could save you a lot of time and money down the road.
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