Roth vs. Traditional Deductible IRA

By Matthew Lea
Editor, mPower

In This Story Assessing Your Situation Long-term, Roth Beats the Traditional The Third Choice: Nondeductible IRA Distributions Dictate Contributions

Choosing between a deductible traditional IRA and a nondeductible Roth IRA presents an interesting dilemma: tax deduction now or tax advantage later? Throw in the third option of a nondeductible traditional IRA and things can get really confusing. What should you do?

Financial planners from sea to shining sea say to run with the Roth if you are eligible, especially if you are young. The tax break you give up initially will likely be more than recouped after years of compounding.

minute: read this article at a glance.

Technical Terms Modified adjusted gross income Individual Retirement Account (IRA) 401(k)

With the rise in popularity of defined-contribution plans like
401(k)s, the IRA has lost some of its original luster as an independent retirement savings vehicle, offering only a $2,000 annual contribution limit for the past 20 years.

This could soon change, giving IRAs the ability to stand on their own two feet as a singular retirement vehicle. Legislation to raise IRA contribution limits to $5,000, or $7,500 for those who qualify for "catch-up" contributions, is currently moving through the Senate. Had annual IRA contribution limits been indexed to inflation from their inception in 1974, investors would already be able to max out at over $5,000.

In the meantime, retirement savers with other options have looked elsewhere to stash their money, using IRAs primarily as holding accounts for rollovers, where their value in estate planning can be paramount.

Whether an IRA is your only means of tax-deferred retirement savings, or you've maxed out your other tax-deferred accounts and want to use an IRA as the icing on your retirement cake, you need to consider which IRA is best for you. There are three options that may be available to you: a Roth IRA, a deductible traditional IRA, or a nondeductible traditional IRA. The first two offer more advantages than the third, but income limits apply. Overall, contributing to a Roth IRA may put you ahead in the long run.

Indeed. "You may not get a tax break" if you choose a Roth over a deductible IRA, said Fred Siegel, president of The Siegel Group, Inc., an investment management firm based in New Orleans, La. "But, you get a tax advantage."

Assessing Your Situation

Before making an IRA contribution, you need to determine what kind, if any, you are eligible to make.

If you or your spouse were covered by an employer retirement plan, and you wanted to contribute to a traditional IRA, you may be entitled to only a partial deduction or no deduction at all, depending upon your income and filing status. Your deduction begins to decrease when your income rises above a certain amount and is eliminated altogether when it reaches a higher amount.

To determine your contribution eligibility for a deductible IRA, you will need to calculate your modified adjusted gross income (MAGI), or Modified AGI. Check out "How do I calculate the periodic payments?" under "Distributions" in our FAQ.

For 2000, if you are covered by a retirement plan at work, your traditional IRA deduction will be phased out if your MAGI falls between:

• $32,000 and $42,000 for a single individual (or head of household),
• $52,000 and $62,000 for a married couple (or a qualifying widow[er]) filing a joint return, or
• $0 and $10,000 for a married individual filing a separate return.

To contribute to a Roth, you need to meet a different set of eligibility rules. If you're single and earned more than $110,000, or married, filing jointly and earned more than $160,000, you won't be able to open a new Roth IRA, or contribute to an existing one. For phase out levels with a Roth IRA, see the chart below.

Long-term, Roth Beats the Traditional

If you have a long time to go before you'll need the money, and are considering whether to contribute to a Roth or make a tax-deductible traditional IRA contribution, all of the financial planners interviewed for this article suggest going with a Roth. For those with a shorter time horizon, making up for the nondeductible contribution may not be possible.

"By giving up a relatively small (tax) benefit at the beginning, you might be able to leverage that into a big benefit (in retirement)." — Laurence I. Foster, CPA/PFS, partner at Richard A. Eisner and Company L.L.P.

The money you contribute is taxable, but the distributions you take in retirement aren't, although you will have to pay taxes on the gains made in the account. But, in retirement, you will most likely be in a low tax bracket.

"A Roth IRA is better than a deductible IRA in every case. If you run the numbers, after any accumulation period of 25 years or more, the net after-tax amount available is significantly greater because it is not taxable (at withdrawal)," said Louis A. Reisman, a lawyer and teacher at UCLA Extension, specializing in estate and retirement planning. "Even if you figure in the tax break at the beginning."

This means that the longer you have to let a Roth IRA grow, the more time you have to make up the money you didn't save by contributing to a traditional IRA and taking a tax break.

Let's suppose a 25-year-old sets aside $2,000 into a deductible IRA and the same amount in a Roth IRA. Further, we'll assume a 10 percent annual return and a 25 percent tax rate.

By age 65, the money in the traditional IRA will have grown to $90,000, but when the tax is paid on the gains, the net proceeds are $68,000. The $2,000 in the Roth IRA will reach $90,000 in 40 years and that money is available tax-free. Of course, it was taxable money you contributed to the Roth, and pretax money to the traditional IRA. Some argue that this means your $2,000 contribution to a Roth was more "expensive" than the $2,000 contribution to the deductible IRA.

"By giving up a relatively small (tax) benefit at the beginning, you might be able to leverage that into a big benefit (in retirement)," said Laurence I. Foster, CPA/PFS, partner at Richard A. Eisner and Company L.L.P.

In fact, if the contribution limits of a Roth IRA and a 401(k) plan were equal (and without a 401(k) match), the Roth would be a much better retirement savings tool in the long run. For more information about this, read Roth IRA vs. 401(k): Which Plan Has the Advantage?

The Third Choice: Nondeductible IRA

The nondeductible IRA, according to the financial planners interviewed for this article, is becoming less and less popular due to the popularity and flexibility of the Roth. However, if you don't qualify for a Roth (your income is too high), this may still be the right choice for you.

There are drawbacks to this option. When you start a nondeductible IRA, you have to file a special form with the IRS telling them that you have made a contribution. And, at the end of each year, you have to note the balance of the account with the IRS. "It is not tough, but it's a hassle," said Reisman.

"The real issues now are turning into IRA distribution, not IRA contribution. Contribution is easy to decide. The not-so-easy part is deciding how to take the money out." — Louis A. Reisman, a lawyer and teacher at UCLA Extension, specializing in estate and retirement planning.

But, this brings up another interesting point. If you don't qualify for either the traditional or the Roth IRA, it most likely means you are contributing to a tax-deferred plan at work and are relatively highly paid. In this case, saving $2,000 in a nondeductible IRA, and dealing with the account maintenance, may not be worth the trouble, says Reisman.

Investment options that allow for a higher contribution limit, less hassle and a greater amount of flexibility may be right for you; possibly something outside of the tax-deferred, retirement savings realm. You should consult a financial planner to help weigh your options.

Distributions Dictate Contributions

Deciding what kind of contribution you can make is the easy part. The rules are fairly cut-and-dried. "The real issues now are turning into IRA distributions, not IRA contributions. Contribution is easy to decide. The not-so-easy part is deciding how to take the money out," said Reisman.

With a traditional deductible IRA, you have to take minimum distributions once you turn 70½, whereas with a Roth, you don't ever have to take the money out. Converting from a traditional IRA to a Roth is another complex area. Generally, the nearer you are to retirement, the less appealing this conversion becomes due to the fact that it is tougher to recoup the tax bite you'll incur.

The tax laws regarding withdrawals can be rather intricate and can often vary from investor to investor. This is where solid estate planning is essential.

Another thing you'll want to think about is your IRA beneficiary. For example, you can set up different IRAs for each beneficiary, leaving different amounts to different people. Generally, a Roth IRA gives beneficiaries more flexibility in terms of spreading out the distributions (and the taxes) over time, but not in all cases. Further, if you are inclined to give to charities, you can set up an IRA to cover this sort of gift. For many, "It's easier than dealing with it in your will," said Foster.

Related Reading Your Guide to Understanding IRA Fees Expand College Savings with Education IRAs

Determining how (and how much) to save in an IRA is an assessment investors must make based upon their own goals and current means. "The real question is what you are comparing (your savings habits) to," said Reisman. "If a client walks in, I can't give him an abstract answer. We must sit down and appraise the whole situation." 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Roth vs. Traditional Deductible IRA

By Matthew Lea
Editor, mPower

In This Story Assessing Your Situation Long-term, Roth Beats the Traditional The Third Choice: Nondeductible IRA Distributions Dictate Contributions

Choosing between a deductible traditional IRA and a nondeductible Roth IRA presents an interesting dilemma: tax deduction now or tax advantage later? Throw in the third option of a nondeductible traditional IRA and things can get really confusing. What should you do?

Financial planners from sea to shining sea say to run with the Roth if you are eligible, especially if you are young. The tax break you give up initially will likely be more than recouped after years of compounding.

minute: read this article at a glance.

Technical Terms Modified adjusted gross income Individual Retirement Account (IRA) 401(k)

With the rise in popularity of defined-contribution plans like
401(k)s, the IRA has lost some of its original luster as an independent retirement savings vehicle, offering only a $2,000 annual contribution limit for the past 20 years.

This could soon change, giving IRAs the ability to stand on their own two feet as a singular retirement vehicle. Legislation to raise IRA contribution limits to $5,000, or $7,500 for those who qualify for "catch-up" contributions, is currently moving through the Senate. Had annual IRA contribution limits been indexed to inflation from their inception in 1974, investors would already be able to max out at over $5,000.

In the meantime, retirement savers with other options have looked elsewhere to stash their money, using IRAs primarily as holding accounts for rollovers, where their value in estate planning can be paramount.

Whether an IRA is your only means of tax-deferred retirement savings, or you've maxed out your other tax-deferred accounts and want to use an IRA as the icing on your retirement cake, you need to consider which IRA is best for you. There are three options that may be available to you: a Roth IRA, a deductible traditional IRA, or a nondeductible traditional IRA. The first two offer more advantages than the third, but income limits apply. Overall, contributing to a Roth IRA may put you ahead in the long run.

Indeed. "You may not get a tax break" if you choose a Roth over a deductible IRA, said Fred Siegel, president of The Siegel Group, Inc., an investment management firm based in New Orleans, La. "But, you get a tax advantage."

Assessing Your Situation

Before making an IRA contribution, you need to determine what kind, if any, you are eligible to make.

If you or your spouse were covered by an employer retirement plan, and you wanted to contribute to a traditional IRA, you may be entitled to only a partial deduction or no deduction at all, depending upon your income and filing status. Your deduction begins to decrease when your income rises above a certain amount and is eliminated altogether when it reaches a higher amount.

To determine your contribution eligibility for a deductible IRA, you will need to calculate your modified adjusted gross income (MAGI), or Modified AGI. Check out "How do I calculate the periodic payments?" under "Distributions" in our FAQ.

For 2000, if you are covered by a retirement plan at work, your traditional IRA deduction will be phased out if your MAGI falls between:

• $32,000 and $42,000 for a single individual (or head of household),
• $52,000 and $62,000 for a married couple (or a qualifying widow[er]) filing a joint return, or
• $0 and $10,000 for a married individual filing a separate return.

To contribute to a Roth, you need to meet a different set of eligibility rules. If you're single and earned more than $110,000, or married, filing jointly and earned more than $160,000, you won't be able to open a new Roth IRA, or contribute to an existing one. For phase out levels with a Roth IRA, see the chart below.

Long-term, Roth Beats the Traditional

If you have a long time to go before you'll need the money, and are considering whether to contribute to a Roth or make a tax-deductible traditional IRA contribution, all of the financial planners interviewed for this article suggest going with a Roth. For those with a shorter time horizon, making up for the nondeductible contribution may not be possible.

"By giving up a relatively small (tax) benefit at the beginning, you might be able to leverage that into a big benefit (in retirement)." — Laurence I. Foster, CPA/PFS, partner at Richard A. Eisner and Company L.L.P.

The money you contribute is taxable, but the distributions you take in retirement aren't, although you will have to pay taxes on the gains made in the account. But, in retirement, you will most likely be in a low tax bracket.

"A Roth IRA is better than a deductible IRA in every case. If you run the numbers, after any accumulation period of 25 years or more, the net after-tax amount available is significantly greater because it is not taxable (at withdrawal)," said Louis A. Reisman, a lawyer and teacher at UCLA Extension, specializing in estate and retirement planning. "Even if you figure in the tax break at the beginning."

This means that the longer you have to let a Roth IRA grow, the more time you have to make up the money you didn't save by contributing to a traditional IRA and taking a tax break.

Let's suppose a 25-year-old sets aside $2,000 into a deductible IRA and the same amount in a Roth IRA. Further, we'll assume a 10 percent annual return and a 25 percent tax rate.

By age 65, the money in the traditional IRA will have grown to $90,000, but when the tax is paid on the gains, the net proceeds are $68,000. The $2,000 in the Roth IRA will reach $90,000 in 40 years and that money is available tax-free. Of course, it was taxable money you contributed to the Roth, and pretax money to the traditional IRA. Some argue that this means your $2,000 contribution to a Roth was more "expensive" than the $2,000 contribution to the deductible IRA.

"By giving up a relatively small (tax) benefit at the beginning, you might be able to leverage that into a big benefit (in retirement)," said Laurence I. Foster, CPA/PFS, partner at Richard A. Eisner and Company L.L.P.

In fact, if the contribution limits of a Roth IRA and a 401(k) plan were equal (and without a 401(k) match), the Roth would be a much better retirement savings tool in the long run. For more information about this, read Roth IRA vs. 401(k): Which Plan Has the Advantage?

The Third Choice: Nondeductible IRA

The nondeductible IRA, according to the financial planners interviewed for this article, is becoming less and less popular due to the popularity and flexibility of the Roth. However, if you don't qualify for a Roth (your income is too high), this may still be the right choice for you.

There are drawbacks to this option. When you start a nondeductible IRA, you have to file a special form with the IRS telling them that you have made a contribution. And, at the end of each year, you have to note the balance of the account with the IRS. "It is not tough, but it's a hassle," said Reisman.

"The real issues now are turning into IRA distribution, not IRA contribution. Contribution is easy to decide. The not-so-easy part is deciding how to take the money out." — Louis A. Reisman, a lawyer and teacher at UCLA Extension, specializing in estate and retirement planning.

But, this brings up another interesting point. If you don't qualify for either the traditional or the Roth IRA, it most likely means you are contributing to a tax-deferred plan at work and are relatively highly paid. In this case, saving $2,000 in a nondeductible IRA, and dealing with the account maintenance, may not be worth the trouble, says Reisman.

Investment options that allow for a higher contribution limit, less hassle and a greater amount of flexibility may be right for you; possibly something outside of the tax-deferred, retirement savings realm. You should consult a financial planner to help weigh your options.

Distributions Dictate Contributions

Deciding what kind of contribution you can make is the easy part. The rules are fairly cut-and-dried. "The real issues now are turning into IRA distributions, not IRA contributions. Contribution is easy to decide. The not-so-easy part is deciding how to take the money out," said Reisman.

With a traditional deductible IRA, you have to take minimum distributions once you turn 70½, whereas with a Roth, you don't ever have to take the money out. Converting from a traditional IRA to a Roth is another complex area. Generally, the nearer you are to retirement, the less appealing this conversion becomes due to the fact that it is tougher to recoup the tax bite you'll incur.

The tax laws regarding withdrawals can be rather intricate and can often vary from investor to investor. This is where solid estate planning is essential.

Another thing you'll want to think about is your IRA beneficiary. For example, you can set up different IRAs for each beneficiary, leaving different amounts to different people. Generally, a Roth IRA gives beneficiaries more flexibility in terms of spreading out the distributions (and the taxes) over time, but not in all cases. Further, if you are inclined to give to charities, you can set up an IRA to cover this sort of gift. For many, "It's easier than dealing with it in your will," said Foster.

Related Reading Your Guide to Understanding IRA Fees Expand College Savings with Education IRAs

Determining how (and how much) to save in an IRA is an assessment investors must make based upon their own goals and current means. "The real question is what you are comparing (your savings habits) to," said Reisman. "If a client walks in, I can't give him an abstract answer. We must sit down and appraise the whole situation." 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.