Choosing between a Traditional IRA and a Roth IRA

Generally, you have until April 15, 2021 to make an IRA contribution for 2020. Prior to making a contribution you will need to decide whether that contribution should be made to a traditional IRA or a Roth IRA.

With a traditional IRA, any earnings would grow tax deferred, but are taxable when distributed. With a Roth IRA, any earnings grow tax-deferred, and are tax free if distributions meet certain requirements. A Roth IRA distribution is tax free, if it occurs at least 5 years after the Roth deposits are first funded; and- if at the time the distribution occurs, the Roth Account owner is at least age 59½, disabled or the distribution is used for first-time homebuyer purposes- subject to a lifetime limit of $10,000.

While income taxes are likely a driver for whatever choice you make, there are many factors to consider in making your decision. The following three considerations can be helpful as part of the decision-making process.

Eligible Compensation 

You (or in some cases, you or your spouse) must have received eligible compensation in 2020, in order to make a contribution to an IRA for 2020.  Eligible compensation generally includes payments that you received for working such as wages, salaries, tips, bonuses, professional fees, and self-employment income.

Contribution Limits 

For more information on IRA contribution limits please see our article How much can I contribute to my IRA?” 

Exceeding contribution limits could result in penalties being owed to the IRS, unless the excess amount is timely and properly corrected. It is important to stay under the limits for this reason. 

Modified Adjusted Gross Income (MAGI) Income and Tax Deductions 

For more information on IRA income limits and tax deductibility, please see our article “What are the income limitations for IRA contributions?

Making the Choice

Even if you cannot take a deduction from your traditional IRA contribution, you may still be able to make non-deductible contributions to your traditional IRA. Amounts attributed to non-deductible (Roth IRA) contributions are nontaxable when distributed from their IRA, but any earnings would be taxable.

In some cases, even if you are not eligible to claim a deduction for traditional IRA contribution, but eligible to make a contribution to a Roth IRA, it may make better tax and financial sense to make a contribution to a Roth IRA. With the Roth IRA, you get the earnings tax free, provided the distribution is qualified. (1)

If you are unsure about which IRA to choose, you may decide to split your contributions between both types of IRAs, if you are eligible to do so.

 

(1) The information contained in this article is general in nature and based on authorities that are subject to change. This article is not intended to provide investment advice, legal, tax or accounting advice, and readers should always consult an accountant or tax advisors concerning the application of tax laws to their particular situations.

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