Monday, January 23, 2017

Do You Need an IRA? Traditional or Roth?

While it's too late to max out your 401k account for 2016, it's not too late to open or fund an IRA (Individual Retirement Arrangement). You have until April 17, 2017, to designate a contribution for 2016. You can contribute up to $5500—or $6500 if you're over age 50.

But if you already have access to a workplace retirement plan, do you need an IRA? And if so, should you fund a traditional IRA or a Roth?

That depends.

Anyone under age 70 1/2 with taxable compensation can contribute to a traditional IRA. If you're not covered by a workplace retirement plan, you can deduct your IRA contributions on your income tax return regardless of your income. Even if you have a workplace plan, you can deduct your contributions provided your income is under certain levels (depending on your filing status). If you don't qualify for deductible contributions, you can still make nondeductible contributions. This means you don't get a tax deduction in the year you fund the account, but when it comes time to withdraw the money, you'll only owe taxes on any gains. You're required to start withdrawing the money and paying the applicable taxes once you reach age 70 1/2 or you'll face stiff penalties... basically, the government will take it if you don't.

A Roth IRA is funded with after-tax money, but eligible withdrawals of contributions, as well as gains, are not taxed. You can continue to contribute to your Roth account at any age, as long as you meet the income requirements, and there's no minimum distribution rule for the original owner (i.e., as long as it's not a Roth account you inherited). To be eligible to contribute to a Roth, your modified adjusted gross income must be below certain amounts (depending on filing status). But since 2010, there's a loophole in the law that allows anyone, regardless of income, to convert a traditional IRA to a Roth after paying the applicable taxes.

If you don't qualify for a tax deduction for a contribution to a traditional IRA, but you do meet the income eligibility requirements for a Roth, it's a no-brainer. Go for the Roth. Otherwise, you have a decision to make: is it better to pay the taxes now or later? Do you think you'll be in a higher or lower tax bracket after you retire and begin making withdrawals? Many people believe taxes can only go up and thus, the Roth contribution or Roth conversion is the better move. But your situation could be different.

A financial planner once told me I was being irresponsible by maxing out my tax-deductible 401k account, that I should have made Roth contributions instead. One argument he gave is that a large traditional retirement plan can leave an unwanted tax burden on your heirs, whereas with a Roth, the tax has already been paid for them. But because I don't have children, my beneficiary will most likely be a charity, and the charity won't have to pay income taxes regardless of what type of account they inherit. However, if one of your financial goals is to leave a legacy for your heirs, consider a Roth. In fact, many 401k plans are now offering a Roth option, so workers can contribute after-tax money instead of the traditional pre-tax contributions.

I prefer to hedge my bets, so I have pre-tax 401k money (which since my retirement, has been rolled into a traditional IRA), as well as Roth accounts. I really don't know what my tax situation will be later, or how the tax laws will change.

If you can spare the money to contribute to both a workplace plan and an outside IRA, by all means, do both. If you can't max out both, I suggest contributing to your workplace plan at least up to any employer match (to do less is leaving free money on the table) and then putting additional money into a Roth IRA at a discount brokerage such as Fidelity, Vanguard, Schwab, etc., if you qualify. A large discount brokerage will most likely offer access to more diverse investment products than your workplace plan.

Whatever you decide, even if it turns out not to be the ideal choice, contributing something is better than contributing nothing. If you put away as much as you can whenever you're able, you'll increase your chances for a comfortable retirement.

What tips do you have for retirement contributions? I'd love to hear your comments.

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