Which Type of IRA Should I Choose?

While many people have a work-based retirement plan of one sort or another, that plan may not be all you need to prepare for retirement.  Today we are going to take a look at Individual Retirement Accounts--accounts that you fund but which the government helps you with by deferring or foregoing taxes.

Rollover IRAs:

When you leave an employer that has a 401(k) or similar plan, you are offered the opportunity to roll the money from the employer plan into an IRA.  The transfer has to take place between the custodians (companies holding the money) but a rollover puts you in charge of the investments and often allows less expensive options that what the employer may offer.  

Money is a rollover IRA remains there until withdrawn.  If you withdraw it before age 59.5, you have to pay penalties as well as taxes. 

Individual Retirement Account

IRAs are accounts individuals open with banks or brokerage houses and to which pre-tax dollars are contributed.  When you do your taxes, the amount you contribute to your IRA is deducted from the amount of money on which you owe taxes.  As of 2017, individuals under 50 are allowed to contribute $5,500 to an IRA yearly; those over 50 are allowed to contribute $6,500 annually.  

In order to contribute to an IRA, you must have at least as much earned (as opposed to investment) income as you contribute, or be the spouse of an earner.  

IRAs may be invested in mutual funds, stock, bonds, or just about any other type of investment except individually-owned real estate.  You get to decide where to open the account and in what to invest.  You may choose to have one IRA or multiple ones (but the contribution limit is per person, not per account).  

Once money is put in an IRA, withdrawing it before age 59.5 means penalties on top of the taxes owed.  There are a few exceptions, such as the purchase of a home, payments of medical expenses and payments for college, but in general you should consider money in your IRA to be for retirement, not for the new car or other pre-retirement expenses.

Like the 401(k), earnings within the IRA accrue tax-deferred.  If money is withdrawn after age 59.5, that money will be taxed at your then current tax rate.  Also like the 401(k), you are required to take a minimum distribution each year after you are 70.5.  

If there is still money in your IRA when you die, it is distributed to the named beneficiaries (not through your will), and as is true with distributions from a 401(k) they will owe taxes on the money unless steps are taken to defer them. 

Roth IRA

The Roth IRA is a relatively new type of account. 

In order to contribute to a Roth IRA, single people must have a modified adjusted gross income below $133,000, but contributions are reduced starting at $118,000. If you are married, your MAGI must be less than $196,000, with reductions beginning at $186,000.   You must also have earned income (as opposed to investment income) of at least the amount of your contribution.   

While regular IRAs allow you to defer the taxes you pay on both the money you place in the account and the money earned via the account, contributions to the Roth IRA are taxed before they are deposited.  However, the money earned on the account is NEVER subject to income tax.  

Another advantage of the Roth IRA is that you can withdraw your contributions penalty-free at any time, and since you have already paid taxes on them, they will not add to your income that year.  This makes the Roth IRA a good place for young people who aren't sure what the future will bring to save money.  While you don't want to have to take money out of your Roth IRA, the money is accessible if you are laid off, or even if you need a new car.

While regular IRAs require that those 70.5 and older take minimum required distributions, Roth IRAs do not.  If you do not need the money that is in your Roth IRA, you can leave it there to continue to grow.  When you die, any money left in a Roth IRA passes to the beneficiary(ies), and those beneficiaries do not have to pay taxes on that money.  

"Back-Door" or "Conversion" Roth IRAs

As noted above, the main advantages of the Roth IRA are that you never pay taxes on earnings and you are able to leave the account to beneficiaries without subjecting them to income taxes on the money.  However, as also noted above, if you make too much money you cannot contribute directly to a Roth IRA.  But, there is a "back door".  The law allows owners of regular IRAs to convert those IRAs to Roth IRAs.  If you choose to do so, taxes become due that year on the converted portion.  So, if you convert a $10,000 IRA to a Roth IRA,  your taxable income that year increases by $10,000, giving you an additional tax bill of $2,100 if you are in the 21% tax bracket. 

There are quite a few calculators online that will tell you whether it is likely to be advantageous to you to convert your current regular IRA to a Roth IRA (and it can be done a little at a time, you don't have to move the whole account in one year).  Basically you have to consider how long you have until you are likely to need the money, what  your tax bracket is now, and what it will likely be in the future and whether you have cash available with which to pay the taxes. 

Those who do not qualify to put money into a Roth IRA directly are allowed to convert a regular IRA into a Roth IRA.

Which IRA Is Best for Me?

The advantage of a regular IRA is immediate tax relief.  Tax brackets this year for those with taxable income over $91,000 range from 28% to 39.6%.  In those cases, a regular IRA allows you to invest 1/3 more money than a Roth IRA does.  If you are in peak earning years and expect your tax bracket to decrease significantly after retirement, the regular IRA may be your best bet, particularly if you plan to withdraw (and spend) the money.

While the Roth IRA does not give you immediate tax relief, you never owe taxes on the money from the account and you never have to take money out of it.  If you expect your tax bracket later in life to be similar to or higher than your current bracket, the Roth becomes more attractive.  

The main thing to remember about either IRA is that it doesn't make money unless you put money in it, there won't be any money to take out.