If you earn taxable income, you’re eligible to open an IRA (Individual Retirement Arrangement, also known as an Individual Retirement Account). The two types of IRA’s I’m going to discuss here are the Traditional IRA and the Roth IRA. A Traditional IRA is typically tax-deductible. When you withdraw at retirement age the money will be taxed at the current rate of ordinary income. With a Roth IRA, you contribute after-tax dollars so when you withdraw at retirement age, you don’t have to pay taxes on those withdrawals as long as you’ve had the Roth for over 5 years (known as the seasoning period)!!
While there isn’t and income limitation to contribute to a Traditional IRA, there are limits to what you can take as a tax deduction. According to IRS Publication 590, you can take a deduction for contributions to a Traditional IRA if your modified Adjusted Gross Income (AGI) is:
- More than $92,000 but less than $112,000 for a married couple filing a joint return or a qualifying widow(er),
- More than $58,000 but less than $68,000 for a single individual or head of household, or
- Less than $10,000 for a married individual filing a separate return.
If you either live with your spouse or file a joint return, and your spouse is covered by a retirement plan at work, but you are not, your deduction is phased out if your modified AGI is more than $173,000 but less than $183,000. If your modified AGI is $183,000 or more, you cannot take a deduction for contributions to a traditional IRA.
There is an income limitation on whom can contribute to a Roth IRA. According to IRS Publication 590, you can contribute to a Roth IRA if:
- Your filing status is married filing jointly or qualifying widow(er) and your modified AGI is at least $173,000. You cannot make a Roth IRA contribution if your modified AGI is $183,000 or more.
- Your filing status is single, head of household, or married filing separately and you did not live with your spouse at any time in 2012 and your modified AGI is at least $110,000. You cannot make a Roth IRA contribution if your modified AGI is $125,000 or more.
- Your filing status is married filing separately, you lived with your spouse at any time during the year, and your modified AGI is more than -0-. You cannot make a Roth IRA contribution if your modified AGI is $10,000 or more.
The government sets a limit on how much you can contribute to an IRA. That limit is $5,000 ($6,000 if you are age 50 or older)
When you turn 70 ½, you have to take distributions from your Traditional IRA. Roth IRA’s, however, have no such requirement.
Which to choose?
Generally speaking, if your tax rate is expected to be greater than or equal to your current tax rate, you should invest using a Roth IRA. However, if you have more than 5 years until retirement, I would suggest that you open a Roth IRA regardless of the anticipated future tax rate. The rule of thumb is good a guideline but the nature of government is unpredictable. Who is to say what tax rates will be 10, 20, or 30 years from now? I can guarantee this, when you retire and are taking tax free distributions, you won’t remember, or care, what the tax rate is or was.
How to contribute to retirement accounts
If $5,000 is greater than or equal 15% of your income, then you should contribute your 15% to a Roth IRA and call it a day!
On the other hand, if $5,000 is less than 15% of your income, max out a Roth IRA and then contribute to the remaining percentage to an employer sponsored plan if available (401k, 403b, or 457b).
If you do not have an employer sponsored plan to contribute to you may want to consider a regular investment account since long term capital gains are currently taxed at 15%. Remember, to take advantage of that 15% capital gains rate, you will have to hold on to those investments for more than a year.
One last thing
An IRA is more flexible than an employer sponsored plan because you can invest it in whatever you like (stocks, bonds, mutual funds, real estate, etc). Many employer sponsored plans are limited in their investment options.