IRAs in a nutshell

We often get asked, what’s the difference between a Roth IRA and a Traditional IRA? There are several key differences. Here are THREE YOU SHOULD KNOW:

  1. Taxation. It’s basically a question of “now or later?”. With a Traditional IRA, you get a tax break today and you pay taxes later (when you take the money out). With a Roth IRA, you don’t get a tax break today, but you also don’t have to pay taxes later on the money that you take out. In addition, the growth you see in a Roth IRA is generally tax FREE, a phrase that makes us all smile.\Required Minimum Distributions. Once you reach age 70 ½, you will be required to start taking distributions from your Traditional IRA (whether you want to or not). This goes back to the taxation. You got a tax break back when you contributed, so the IRS wants to make sure you start taking the money out during your lifetime, so they can recoup the tax break they gave you. A Roth IRA is different. Since there was no tax break to begin with, there are no required distributions. If you wanted to, you could leave all the money in your Roth IRA to future generations, and never take it out for yourself at all.

  2. Required Minimum Distributions. Once you reach age 70 ½, you will be required to start taking distributions from your Traditional IRA (whether you want to or not).  This goes back to the taxation.  You got a tax break back when you contributed, so the IRS wants to make sure you start taking the money out during your lifetime, so they can recoup the tax break they gave you.  A Roth IRA is different.  Since there was no tax break to begin with, there are no required distributions.  If you wanted to, you could leave all the money in your Roth IRA to future generations, and never take it out for yourself at all.

  3. Contributions. You can contribute to a Roth IRA at any age, as long as you have “earned income” and meet other requirements laid out by the IRS. That means a child who earns money from a photo shoot could potentially put that money into a Roth IRA. An 80-year-old woman who earns money from selling magazines could potentially put that money into a Roth IRA. Roth IRA restrictions involve income, not age. Traditional IRA restrictions involve both. You cannot make contributions to a Traditional IRA after age 70 ½, period.

Let’s say you have a Traditional IRA and you are wondering whether you should convert it to a Roth IRA. Here are a few reasons to consider conversion of a Traditional IRA to a Roth: IF…

  1. Your Federal Rate May be Higher in the Future – If you expect, between future Federal tax increases and your individual earnings levels, you’ll be taxed at a much higher Federal tax rate in the future, consider converting all or part of a traditional IRA to a Roth IRA, which is potentially a great hedge against those higher rates.

  2. You May Not Need Your IRA funds at 70 ½ – After you turn 70 ½, you must begin taking annual “required minimum distributions” from a traditional IRA, but not from a Roth.

  3. You’re Leaving Money to Children or Family – You can leave the Roth IRA alone and, after your death, your named beneficiaries / heirs can stretch out tax-free withdrawals over their own lifespans, buying decades of extra tax-free growth.

  4. Market considerations – If your IRA account is at a low value, after the current market decline, consider a Roth conversion to pay tax on the lower value, then let it grow tax-free.

  5. You Lost a Spouse This Year – Take advantage of the lower tax rate as under married, filing jointly, before you are considered single for filing status next year.

  6. Your Social Security Might Be Taxed – Up to 85% of your Social Security retirement check is taxable, but only if your other income is above a certain level. Roth distributions aren’t counted as income for the purposes of that calculation. If you will have modest retirement income, a Roth conversion may help you limit the tax on your Social Security check.

Note that there is a deadline of December 31st to CONVERT your traditional IRA to a Roth IRA, or a portion of it, so if you’re considering this, you should probably plan on doing the paperwork soon.

Regardless of which type of IRA you own, another top question I often hear is, when should I contribute to my IRA? For this, there are three answers:

  1. Anytime is better than not at all.

  2. If you can, put contributions on “auto pilot” and pay them monthly, like a bill. Monthly contributions generally average out better over the long term due to dollar cost averaging*. And many people find it easier to put away a little each month, rather than coming up with the full contribution amount in a lump sum all at once.

  3. If you prefer to make a one-time contribution, consider the timing. October may be one of the most “scary” times of the year for investors, because some of the largest drops in the US markets have occurred in October. “The Panic of 1907,” the crash of 1929’s Black Tuesday, and in 1987 we had Black Monday. Lots of “Black” and “Panic” are associated with October. What should this mean to the average investor? Opportunity! Often, October marks the low point of the rolling 1 year period. So it can be a great time to make that lump sum contribution and catch the odds of buying at the lowest point of the year.

*Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.

There you have it! “IRA’s in a nutshell.” We hope this will help you as you squirrel away your dollars for your future, and the future of your families.

IRA Squirrel