Traditional IRA and Roth IRA

By Kelly Woo, CFP®

Many consider making contributions to an IRA (Individual Retirement Account) for tax-saving purposes. When contributing, it is important to check specific qualifications and limitations before participating to avoid incurring possible IRS penalties, taxes, and additionally added interest. Oftentimes, the opportunity to invest into either Traditional IRA and/or Roth IRA is overlooked because of the misunderstanding that since the contribution limit is small, that in turn, the tax benefit amount received would also be insignificant. Moreover, the fact that there is a 10% penalty clause if funds are withdrawn before the age of 59.5 further takes away from its appeal at the thought of locking away funds for a longer period of time.

Tip: To avoid incurring fees and penalties, always check before making contributions.

Benefits of an IRA Account

However, the benefit of an IRA account is considerably more valuable than what people may think. IRA provides two separate tax benefits through the Traditional IRA and Roth IRA. The benefit of the Traditional IRA is that it provides tax deductions for the year that the contribution was made and additionally, the funds grow tax-deferred. However, at the time of withdrawal, income tax is due. For Roth IRA, initially there are no tax deductions, but the funds grow tax-deferred and at the time of withdrawal all the gains are tax-FREE. As for the penalty associated with earlier withdrawals made before the age of 59.5 due to circumstantial need, if the investment earnings surpass the cost of the 10% penalty, there is no “real loss,” making it a quintessential option despite it being a long-term investment. Additionally, the foreknowledge that there is a 10% penalty clause makes it less likely for retirement assets to be touched before reaching retirement age permitted undisturbed growth of the funds.

Based on the 2018 contribution limit, individuals 50 years and below can contribute up to $5,500 each ($11,000 as a couple) and for those over 50 years of age, they are able to contribute up to $6,500 each ($13,000 as a couple). Heading into 2019, the contribution limit has increased $1,000 and now for those under the age of 50, the limit is $6,000 individually and $12,000 for a couple and for those over 50, the limit is now $7,000 for individual and $14,000 for a couple. For Traditional IRA, the gains are deferred every year and for Roth IRA, the earnings are tax-free, supplying greater benefit with the growing number of years.

Note: IRA contribution limit for 2018-2019.

Fast Fact: High-income earners can still make use of Roth IRA through converting Traditional IRA.

Specifically, for those who are high-income earners, there is another associated appeal to maximize the use of Traditional IRA and Roth IRA by utilizing non-deductible Traditional IRA funds and converting them to Roth IRA. It is known that Roth IRA is only available for those within a specific income threshold, but higher income earners can gain access by converting non-deductible Traditional IRA into Roth IRAs, also known as “Back Door Roth IRA.”

IRA Contribution Limitations

There is no limit as to how much you can convert over from Traditional to Roth IRA—especially for non-deductible Traditional IRA (IRA funds that were not tax deducted), there is no realized-tax on the principal or earnings. This simplifies the conversion process over to Roth IRA as it doesn’t require tax burden at the time of conversion, unlike Traditional IRA that has been tax deducted and therefore must be taxable at the time of conversion. Although the IRA contribution limit for 2019 is $14,000 per couple and it may seem less significant for high-income earners, but the high earners should weigh the benefits of utilizing “Back Door Roth IRA” as this is an opportunity to participate in a Roth IRA while bypassing the income limit rule surrounding Traditional IRA/Roth IRA. Utilizing “Back door Roth IRA” as a long-term retirement planning investment options are one the superlative ways to take advantage of tax-free income during your retirement.

It is important to be aware that NOT everyone can partake in IRAs and there is a limitation based on the amount of income earned per person within a household. If you are single, the contribution limit is permitted up to the amount of income you earn or the IRA limit, whichever is higher. In the case that you are married, you are still able to make contributions to the IRA even if you didn’t work as long as your spouse worked and have earned income. If either you or your spouse is partaking in a company enrolled retirement plan, your Traditional IRA deduction and ability to participate in Roth IRA is determined by the joint income limit. If your joint income is above $121,000, even if you contributed to your Traditional IRA, the amount that you contributed to the traditional IRA may not be tax deductible. If your joint income is above $191,000, you may not be eligible to participate in Roth IRA at all.

In order to avoid unnecessary taxes and penalties for participating in IRAs when ineligible, consulting with a tax adviser/preparer and/or financial professional is advisable. In the next article, I will share more detail about specific qualifications and strategies to participate in Traditional and ROTH IRAs.

Disclosure: Profectus Financial does not provide legal or tax advise. Please consultyour own legal or tax advisor for qualification of any investment or tax strategies. This is for educational purposes only. This is not a soliciation of a particular investment product or company.