Ask The Money Coach

Posts Tagged ‘Traditional IRA’

Q: My husband and I each took  $10,000 early IRA distributions to help pay for a construction loan on a new house. The amount is exempt from the 10% penalty but I do not understand, when it comes to taxes, why it is considered taxable income when I paid income taxes on that money before I put it into an IRA?

A: IRA rules are tricky because there are really two types of IRAs. With the traditional IRA, you put in money and get an upfront tax deduction (provided you meet certain income guidelines, and other requirements). Then, when you take the money out during retirement, you’re taxed on that withdrawal. The point of having a traditional IRA is, of course that you’ll save for your Golden Years. And the government gives you a tax break for doing so – in the form of letting your capital gains go untaxed until you start to withdraw money. As a saver/investor, the hope that the traditional IRA is a good deal based on the assumption that once you are in your post-working years, you’ll be in a lower tax bracket than you were when you were generating an earned income.

But with a ROTH IRA, it works differently. You make contributions and get no upfront tax deduction. Instead, the money grows in your account and those capital gains aren’t taxed — even once you take them out. So while a traditional IRA gives you an upfront tax break, the ROTH gives you a tax break on the back end.I suppose the reason your IRA withdrawal, and all such withdrawals, are taxable is because you did get the benefit of having that money grow tax free within the IRA. In other words, the funds appreciated (or had the potential to appreciate) and collect interest and/or dividends. Such appreciation is considered capital gains and is taxable under current law.

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Q: Should I Roll Over $30,000 in My Traditional IRA Account into a ROTH IRA? I am 50 Years Old.

A: Although the earnings in both types of retirement accounts grow tax-deferred, for longer-term financial planning, I like the benefits of the ROTH IRA over the Traditional IRA. Additionally, recent changes governing IRAs make it more financially advantageous to do a rollover in 2010. Lastly, since you are 50 years old and mentioned having other types of investments (bonds, CDs, retirement accounts, etc), I would seriously explore converting your Traditional IRA into a ROTH IRA. Read on for more details about why a ROTH is likely your better option.

Two major advantages of the ROTH are more control over your withdrawals and a potentially bigger nest egg at retirement. As you know, with a Traditional IRA, your contributions may be tax deductible up front (depending on your income and marital status), but you must later pay taxes on distributions.

With a ROTH IRA, you get no upfront deduction for contributions. However, your stand to get a bigger payoff on the backend – since distributions made from your ROTH IRA won’t be subjected to income taxes in retirement. This combination of tax-free growth and tax free distributions makes the ROTH IRA an especially powerful retirement account. Plus, with the ROTH IRA, you get to make contributions at any age and there’s no mandatory withdrawal age. By comparison, if you have earned income, you can only put money into a traditional IRA up until the year you turn 70 ½, and you must begin taking distributions from Traditional IRAs beginning at age 70 ½.

In 2010, IRA contribution limits for both traditional and ROTH IRAs are $5,000, plus an additional $1,000 for those 50 an older. Starting in 2010, to be eligible to contribute to a ROTH IRA, your modified adjusted gross income must be less than $177,000 for married taxpayers filing joint returns, and less than $120,000 for single taxpayers.

Also noteworthy is that as of 2010, several important changes have occurred impacting Individual Retirement Accounts. First, you no longer have to worry about whether you’re eligible to convert a Traditional IRA to a ROTH IRA due to your income level or your tax-filing status. That’s because previous rules that restricted conversions/rollovers based on income limits and filing status requirements were eliminated effective 2010.

More importantly, the financial sting of doing a rollover has been greatly reduced. In years past, a rollover was considered taxable income in the year you did the rollover. However, for any 2010 rollover from a Traditional IRA to a ROTH IRA, any amounts that would be included as income can be spaced out over two years: in equal parts in 2011 and 2012. This would effectively knock in half any tax bill generated by doing a rollover. The law also still gives you the option of including the entire amount in income in 2010. But most people doing rollovers will want the benefit of spreading that conversion income over two years and deferring taxes in the process.

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