- KEY TAKEAWAYS
- The question that many ask themselves is whether they expect to pay more taxes now or later.
- Your ability to offset your current tax liability with IRA contributions can be limited by your income.
IRAs are not limited like an employer plan in terms of what you can invest in. You are free to choose most types of investments in order to reduce fees or better diversify.
Opening an IRA is straightforward; in fact, it takes just a few clicks at Betterment. What you really need to consider is whether a Roth or Traditional IRA is right for you.
Your first task is to determine what you’re eligible for. Your ability to contribute to a Roth IRA diminishes as your income rises. If you are married filing jointly, your ability to contribute starts phasing out at a modified gross adjusted income (MAGI) of $181,000 for 2014. If you are single, the phaseout begins at $114,000.
Once your MAGI hits $191,000 (married) or $129,000 (single), you can’t contribute to a Roth IRA. Instead, you contribute to a traditional IRA, but deductibility is dependent on other factors (see below). If you want a Roth IRA, you need to make contributions to a Traditional IRA, and then convert it into a Roth.
Consider the Tax Benefits
After you have determined your eligibility, the main issue you need to resolve is how you will be able to best use the tax advantages offered by your IRA:
- Traditional IRA: Receive a tax deduction now (reducing your current income for tax purposes), for the contributions you make. Your money grows tax-deferred, meaning you don’t have pay taxes until you begin withdrawing money from your account later, when the money is taxed at your marginal rate.
- Roth IRA: No tax deduction for your contribution; you pay into the account with after-tax dollars. However, the money grows tax-free, so when it’s time to withdraw the money, you don’t have to pay taxes on it.
The question that many ask themselves is whether they expect to pay more taxes now or later. If you choose a Roth IRA, you pay taxes now, but if you retire in a higher tax bracket, or if taxes go up over time, you are protected from those increases.
With a Traditional IRA, you save money now—providing you can deduct. If you are concerned about your current cash flow, and you want to reduce your tax liability right now, a Traditional IRA can work for you. A Traditional IRA is also ideal if you think that your taxes will be lower later. You put off paying your taxes until you are likely to owe less.
Realize, too, that your ability to offset your current tax liability with your Traditional IRA contributions can be limited by your income. Once you reach certain thresholds (which are set based on whether or not you have access to a retirement plan through your employer), your deduction starts to phase out. See the IRS site for deduction limits.
It’s up to you to consider your situation, and determine whether or not you think that your tax situation will change upon retirement. If you can’t contribute to a Roth IRA due to income restrictions, but you are concerned about the tax situation in the future, you can convert from a Traditional to a Roth (a “backdoor” Roth contribution), and pay taxes now. Generally, if you feel that your taxes will be higher in the future, a Roth is considered a good choice.
This post has been updated with 2014 information.
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