How to decide on a Roth or traditional IRA

Originally published on Marketwatch.com’s website http://www.marketwatch.com/story/how-to-decide-on-a-roth-or-traditional-ira-2015-02-09

It’s getting to be that time of the year when people start thinking about their taxes. One decision many taxpayers will face is whether it makes sense to fund an IRA.

If you don’t have an IRA established yet, you need to be aware that there are two types, the traditional IRA and the Roth IRA. You’ll have to do some calculating to determine which one is best for your situation.

The contribution limits are the same for both types of accounts, $5,500 or $6,500 if you’re over the age of 50 for the 2014 tax year.

The main difference between the two is the way they’re taxed. With the traditional IRA, contributions are deducted from your taxable income. Lowering your adjusted gross income could help you qualify for other tax benefits like child tax credits or student loan interest deductions. Earnings within the IRA account grow tax deferred until it is time to withdraw them. Funds withdrawn from a traditional IRA are subject to ordinary income tax.

Contributions made to a Roth IRA are not tax deductible, but the funds are free from taxation after that, so your account can grow and be distributed to you in the future tax free. There are income limits to be eligible for a Roth, $129,000 for singles and $191,000 for married couples. For the traditional IRA, anyone with earned income can contribute but the tax deductibility is based on income limits and participation in an employer sponsored plan.

With the traditional IRA distributions must begin at age 70 ½, but with the Roth you can leave the money in the tax sheltered account as long as you wish. Roth IRAs are typically far superior for wealth transfer purposes since distributions aren’t mandatory during your lifetime and the beneficiaries’ distributions won’t be subject to income tax. There are different rules for inherited spousal IRAs than for IRAs that are inherited from non-spouses, like parents or grandparents.

If you’re in the process of deciding which type of account is best for you, there are a variety of tools available. Most of the major brokerage firms have calculators and there are many others online. Consider seeking professional advice from your financial adviser and your tax adviser.

One consideration is what your future tax rate will be. It’s impossible to know exactly what tax bracket you’ll be in so you’ll have to estimate. Also, Congress can change the laws at any time, so you have to be prepared for changes in tax policy in the future.