Ask Stacy: Roth or Regular IRA?

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There are very few things you can do now to reduce your 2011 tax bill. One is to put money aside in an Individual Retirement Account, or IRA. But to decide that's a smart move, you've still got to decide whether to go with a Roth or regular. Do you know the difference?

If you’re just sitting down to do your taxes, you may be doing what this reader is attempting: finding ways to reduce the bite. Here’s his question…

Hi Stacy:

Love your site! Seems like every day you offer advice that I can actually use. Here’s my question: I hear a lot about IRAs as a way to pay less taxes and save for retirement. But there are different types of IRAs, like the kind you get at the bank vs. those at brokerage houses. Also, I’ve read that Roth IRAs are a good idea. Should I be putting money in an IRA? And if so, which one?
Thanks and keep up the good work!

Joe in Virginia

Thanks for the kind words, Joe! Here’s the answer to your excellent question…

Why IRAs rock

We know we have to pay taxes on the income we make. So the trick to tax planning is to do whatever we can to reduce our taxable income. One popular way to do that is with a traditional IRA. If you made $50,000 last year, you can contribute $5,000 to an IRA and only pay taxes on $45,000. Nice.

In addition, the money you make in your IRA – interest you earn, or profits you make – isn’t taxed until you take it out at retirement. So you get a tax deduction by contributing to an IRA, and you get to defer the taxes on the earnings.

If you’re the type of person who waits till the last minute to file your taxes, opening an IRA is one way you can get a deduction now against your 2011 income, because you can make 2011 contributions right up until you file your taxes, either on April 17 or even after that if you get an extension.

What’s a Roth IRA?

Both Roth and regular IRAs provide tax deferral on the earnings.  But when it comes to contributions and withdrawals, a Roth is the mirror image of a traditional IRA.

As I explained above, with a traditional IRA, you deduct the money you put in, but you pay taxes on it when you take it out. With a Roth IRA, you don’t get to deduct your deposits, but you don’t pay taxes when you take the money out.

So when you’re asking whether a traditional or Roth is better, what you’re really asking is whether it’s better to get a deduction now or get tax-free income after retirement. More on that in a minute, but let’s get a few more details out of the way by looking at…

Can you contribute?

While most people can contribute to either a Roth or regular IRA, not everyone can, nor can everyone who contributes to a traditional IRA deduct their contributions.

If you’re eligible, for tax year 2011, you can sock away up to $5,000 to either Roth or regular IRA – $6,000 if you’re 50 or older – as long as you have that much in earned income (money from a job vs. stuff like interest income).

According to this page of the IRS website, if you have a retirement plan at work, you can fully deduct contributions to a regular IRA as long as your modified adjusted gross income is $56,000 or less if you’re single and $90,000 or less if you file a joint return. The deduction starts phasing out if you made more, and it disappears completely for modified adjusted gross incomes above $66,000 for singles and $110,000 for marrieds.

If you don’t have an employer-sponsored retirement plan, you can deduct your full contribution to a regular IRA. What if you have a retirement plan at work, your wife doesn’t, and you file a joint return? Check out this IRS table for answers.

There are also income limits when it comes to Roth IRAs. For tax year 2011, if your modified adjusted gross income is more than $169,000 joint or $107,000 single, the amount you can put in a Roth starts dropping and goes away entirely when you reach $179,000 joint and $122,000 single.

What the heck is modified adjusted gross income? Get your adjusted gross by looking at last year’s tax return – it’s right there in black and white. The stuff you use to modify it is on this page of the IRS website.

What should I put in my IRA?

Contrary to what many people believe, an IRA is not an investment – it’s an investment account. In other words, think of it as a bucket. You can fill your bucket with CDs, a savings account, stocks and bonds, or a combination of all of them. You can get one anywhere from the local credit union to major Wall Street firms and discount brokers.

You should invest your IRA the same way you’d invest any other long-term investment account. I have lots of stocks in mine, but you should use whatever investments will make you the most money while providing the least stress.

Traditional or Roth?

Whether a traditional or Roth IRA is best is a source of debate. That’s becasue it ultimately depends on factors you can’t know. For example, if you’re in a high tax bracket now but expect to be in a zero tax bracket when you retire, you’d obviously be better off deducting your contributions with a traditional IRA. If you’re going to be in the same tax bracket when you retire or a higher one, it would be best to use a Roth and pay no taxes when you take the money out.

Unfortunately, there’s no way to know what the tax tables will look like when you retire, especially if it’s far away. And as one of my college tax professors was fond of saying, “In the long term, we’ll all be dead.” In other words, some might argue that today’s bird in the hand – a deduction on a traditional IRA – is better than a tax break at some indeterminate date in the future.  After all, Congress could change the rules and start taxing Roth IRA withdrawals. Or you may not live to see your golden years.

That being said, Roth IRAs are probably the best idea. Taking money out with zero taxes is a nice benefit.

There are calculators online that are supposed to help you decide. Here’s one from Money Chimp and here’s another from Bankrate. But  both require you to know the unknowable: how much you’re going to make on your money, and your tax bracket after retirement. Still, fooling around with them might help you decide.

Stacy Johnson

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