In case you didn’t realize it, time is running out to make your IRA contribution for 2015.
The deadline is creeping up fast…it’s the same date as the tax-filing deadline—April 18, or April 19 if you live in Maine or Massachusetts. Eligible taxpayers can contribute up to $5,500 (or up to the level of earned income, if lower) to a traditional or Roth IRA, or $6,500 if they have reached age 50, for 2015.
While that may seem like a large sum of money, you may be eligible for a tax deduction, and don’t forget about the beauty of the fact your money will multiply over time.
So now that you’re ready to make a contribution, how do you decide which type of IRA in which to invest? There are two kinds of IRAs—traditional and Roth.
Following are some pros and cons of each:
1. Your contribution may reduce your taxable income, thus lowering your 2015 taxes if you’re eligible for the deduction.
2. Earnings on a traditional IRA can grow tax-free until they are withdrawn.
Traditional IRA—(possible) Cons:
1. If you make withdrawals before age 59 ½, you may be required to pay both regular income taxes, plus a 10% penalty.
2. Starting the year you reach age 70 ½, you are required to begin taking required minimum distributions (RMDs), and paying taxes on the distribution amount. If you fail to make the appropriate withdrawals within a certain time frame, you may have to pay a 50 percent excise tax on the amount that was not distributed as required.
3. A traditional IRA contribution may not be fully tax deductible if you are covered by a workplace plan such as a 401(k).
Traditional IRA–the bottom line:
A financial professional can help you estimate your tax savings on a traditional IRA contribution by using a tax-rate chart and multiplying it by the amount of money you contributed to a traditional IRA. That way you can decide whether it’s the right choice for your situation.
1. Your money can grow tax free and your withdrawals are tax free in retirement, as long as you meet certain conditions and requirements.
2. Roth IRAs do not have RMDs during the original owner’s lifetime.
3. You can contribute to a Roth IRA, even if you have contributed to a 401(k) plan, as long as you meet the income eligibility requirements.
4. Because you don’t need to take RMDs with a Roth and it can be willed to your heirs in a tax-free manner, it can also be a useful estate planning tool.
Roth IRA—(possible) Cons:
1. You must pay taxes on your contribution the year you make it.
2. Contributions to a Roth IRA are subject to income limits, and earnings on those contributions (although not the contributions themselves) are subject to early withdrawal penalties.
So which one is right for you?
Well, it depends on whether you’d rather pay taxes now or later. The advantage to paying taxes now with a Roth IRA is that rates will likely be much lower than they will be by the time you retire. But maybe you don’t currently have much cash upfront and you’d rather start contributing to an investment fund right away. In that case, a traditional IRA may be the choice for your situation.
I actually recommend contributing to both traditional and Roth IRAs if you are financially able to do so. That way, you are creating tax diversification within your investment portfolio that will provide both taxable and tax-free options in your golden years. Keep in mind however you can only contribute $5,500, or $6,500 if you are age 50 or older, in total across all of your IRAs.
When it comes down to it, it’s a good idea to go over the details of your particular situation with a financial expert in order to decide whether a traditional IRA, Roth, or both are the right choice for you.