Since the Roth IRA was introduced in 1998, there has been an ongoing debate about whether one should fund a Roth or traditional IRA.
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Unlike a traditional IRA, which provides a tax deduction for the year in which the contribution was made, a Roth IRA offers no immediate tax deduction. All Roth IRA contributions are after-tax. However, assets invested in a Roth IRA grow tax-free, and distributions are also tax-free. A traditional IRA requires owners to begin taking distributions, which are taxed as ordinary income, by age 70-1/2. Meanwhile, Roth IRA has no required minimum distribution requirement during the owner's lifetime, and contributions can be made after age 70-1/2 as long as the owner or spouse has earned income. Beneficiaries who inherit either a traditional and Roth IRA are required to take minimum distributions.
Eligibility and limits
Contribution limits for IRAs in 2016 are $5,500, or $6,500 if you're over age 50. To be eligible to fund an IRA, you or a spouse need to have earned income, and contributions must be made by the time you file your taxes for the prior year. Your eligibility to fund a Roth IRA may phase out, however, depending on your adjusted gross income and filing status. For single taxpayers, the phaseout begins at $117,000, and at incomes above $132,000 Roths are no longer eligible. For taxpayers filing jointly, the range is $184,000 to $194,000.
In theory, a Roth IRA makes perfect sense for many investors. You give up the up-front tax deduction that a traditional IRA offers in exchange for future tax-free income. In addition, once a Roth IRA has been open for five years, contributions (but not investment gains) can be withdrawn tax-free, even if you're under age 59-1/2. Distributions from a Roth IRA, unlike withdrawals from a traditional IRA, are not currently included in the computation used to determine how much of your Social Security benefit is taxable.
Many people find that themselves in a lower tax bracket once they retire, which means they gave up a tax deduction in any year they funded a Roth IRA. A hypothetical study by J.P. Morgan compared deductible and non-deductible retirement account contributions for an individual at a 25% tax rate. The study assumed that the individual contributed either $5,000 to a traditional IRA or $3,750 ($5,000 minus the 25% income tax) to a Roth IRA. The investments both earned 6.5% before retirement and 5% once the individual retired. Once the person retired, distributions were started, with an additional amount coming out of the traditional IRA to pay for taxes. The study determined that if the saver's tax rates remained the same when they retired, then the payout from the accounts would be about equal. But if tax rates decreased, the traditional IRA looked like the better savings vehicle, and if tax rates increased, then the Roth came out ahead.
The bottom line
So whether it makes sense to give up a tax break today in exchange for the potential of future tax-free income depends in part on what you think your tax situation will be in retirement. However, you should also consider the government's ability to change tax rates and rules. There's no reason the government can't decide at some point in the future to begin taxing Roth IRA distributions.
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The article Should You Fund a Roth IRA? originally appeared on Fool.com.
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