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IRA or ROTH IRA

by Kevin McKinley - March 15th, 2015

Posted Under: investing

We’re at that time of year where workers (and their spouses) are trying to decide if they can (and should) contribute to an IRA or a Roth IRA for the 2014 tax year.

The quick answer to those questions is, “Maybe!”, so perhaps some rules of thumb will be helpful.

Who should use an IRA?

Generally speaking, the first criteria in deciding if you should contribute to a tax-deductible IRA is whether or not your taxable income is higher now than it is likely to be in retirement. If this is true, the IRA today is a better bet.

For most people, this situation occurs if you will be in the 15% federal income tax bracket or above right now. That status is determined by the figure on Line 43 of your tax return, and for 2014 it’s $36,900 for single filers, and $73,800 for married couples filing jointly.

The next factor to consider is whether you are eligible to contribute to an IRA. If you or your spouse is covered by an at-work retirement plan, you may not be able to contribute to a tax-deductible IRA (check Publication 590 at www.irs.gov to see if you qualify).

Last but not least, you should only contribute to an IRA if you are unlikely to need the money for anything else until you reach age 59 ½.

If you withdraw money from an IRA before that age, you may owe income taxes on the money pulled out, along with a 10% penalty if the withdrawal isn’t for certain isolated expenses, such as a first-time home purchase, or qualified medical and higher education expenses.

Who should use a Roth IRA?

If you are working and your current income is going to be higher than the aforementioned top of the 15% federal income tax bracket, you’re generally better contributing as much as possible to an at-work retirement plan, such as a 401k or 403b.

Whether it’s due to the pre-tax contributions you make, or you have a lower income in the first place, once your taxable income is below the top of that 15% bracket, you’re probably better off using a Roth IRA.

By definition, you’re in a low tax bracket, so foregoing the deduction offered by the IRA is unlikely to result in a severe loss.

Second and somewhat-related, you may worry that money deposited to a retirement account now might be needed for an emergency before you retire.

If that’s a concern, you’ll be happy to learn that you can withdraw contributions made to a Roth IRA at any time, for any reason, with no taxes or penalties whatsoever.

And the good people at the IRS let us designate withdrawals from Roth IRAs as “contributions”, until the amount we’ve taken out equals what we put in (any earnings withdrawn before 59 ½ may be taxed, and that 10% penalty might be imposed if there are no qualifying reasons for the withdrawal).

Keep in mind that the ability to contribute to a Roth IRA may be limited by your current income. For 2014 full Roth IRA contributions can only be made by single filers with modified adjusted gross income (MAGI) of less than $114,000 ($181,000 for married couples filing jointly).

If you earned more than those amounts you may still be able to make pro-rated contribution to a Roth IRA. But once your 2014 MAGI exceeds $129,000 for singles and $191,000 for married couples, you are ineligible to make a Roth IRA contribution.

Note that teenagers with a small amount of earned income are ideal candidates for making a contribution to a Roth IRA. You can even make the contribution for a teenager (with your money), which may even earn you his or her gratitude, eventually.

When should you make the contribution?

Usually “sooner” is better than “later”, especially if this is the kind of thing that slips your mind. But the deadline to make contributions for either account for the 2014 tax year is April 15th of 2015 (October 15th of this year if you choose to get a six-month extension on filing your taxes).