Boomer dilemma: Traditional or Roth IRA

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If you’re a baby boomer trying to save for retirement, the decision between investing in a traditional or Roth IRA isn’t easy. For most middle-income taxpayers, traditional IRAs offer a tax deduction and tax-deferred growth, while Roth IRAs are funded with after-tax dollars but offer tax-free growth and tax-free distributions in retirement.

If you’re in your 50s, you need to maximize your retirement savings. When making the choice between traditional and Roth IRAs, there are issues to ponder, such as your current and future tax bracket, whether the IRS will permit you to deduct contributions, the current state of your retirement savings and whether you have a retirement plan at work.

If you qualify, the tax deduction allowed by the IRS for a traditional IRA is an enticing perk. Whether you qualify depends on your income and whether you are covered by an employee retirement plan. If you make the maximum allowed contribution of $5,500, or $6,500 for those who are 50 or older, and it’s fully deductible, you deduct that amount from your income on your tax return, reducing your overall taxable income.

Taxes are a particularly vexing part of this decision-making process. The direction of future tax rates is important, but they are impossible to predict. Even trying to figure out whether your tax rate in retirement will be lower than it is now isn’t easy.

“So often, people think in retirement that they are going to need X amount of money per year and (wonder whether) their investments (will) be able to generate that amount per year,” says Lisa Featherngill, a managing director with Abbot Downing in Winston-Salem, North Carolina.

The ABCs of IRAs

IRAs allow you to put away $5,500 into a retirement savings account where the funds will accumulate on a tax-deferred basis. If you’re 50 or older, you can contribute an extra $1,000 per year. IRS rules allow you to split those funds between a traditional IRA and a Roth IRA as long as you meet income guidelines.

Here are the basics of each type of IRA:

Traditional IRA

Deductible: Your contributions are tax-deductible. Your funds will grow tax deferred, but you must pay taxes on your contributions when you withdraw them at retirement. IRS rules mandate that you begin taking distributions from your traditional IRA the year after you turn 70 1/2. The size of those distributions depends on your life expectancy and your spouse’s life expectancy, if you are married.

Consider these tips when choosing a retirement plan.

Nondeductible: If your income is too high to contribute to a tax-deductible IRA or a Roth IRA, you can contribute to a nondeductible IRA. Unlike the more common IRA, your contributions to this type of IRA are not tax-deductible. You can mingle nondeductible contributions with deductible contributions, although the IRS requires you to track the amount of your nondeductible contributions using Form 8606. This is important when you begin to make your required minimum distributions from your IRA because you won’t have to pay taxes on the nondeductible portion. This can get complicated, and taxpayers who do this need to keep good records of their various types of contributions.

Roth IRA

Your contributions to a Roth IRA are not tax-deductible. Distributions from a Roth are tax-free when you withdraw funds in retirement, as long as you own the account for five years and withdraw the money after age 59 1/2. Roth IRAs require no minimum distributions. And now you can convert to a Roth IRA regardless of your income. Bankrate’s video explains Roth vs. traditional retirement account options.

Tax issues prove vexing

There are a couple of different tax issues involved in making the decision between a Roth and traditional IRA. The first is whether you qualify for a tax deduction on a traditional IRA.

If you qualify, the tax deduction for a traditional IRA reduces taxable income in the relevant tax year. If you don’t make a lot of money and want to reduce your taxable income, it might make sense to choose the traditional IRA.

“If maximizing your cash flow right now is really important, you might want to go with the traditional IRA to get that deduction,” says Featherngill. On the other hand, if you can live without the deduction and qualify for a Roth IRA, it will pay off when you are in retirement and can take tax-free distributions.

You need to consider whether you might be in a higher or lower tax bracket in retirement than you are now. You may assume that your tax bracket will be lower in retirement, but that isn’t always the case.

“Nobody who is in the financial advisory business expects income taxes to be reduced in the future in terms of the overall rate. In fact, they are more likely to rise,” says Mike Saghy, senior vice president and portfolio manager at FNB Wealth Management in Pittsburgh.

So you have to think about what income you’ll have from Social Security, a pension plan and retirement plan distributions, and what deductions you might have to offset that income.

“If you think you’re going to be in a higher income tax bracket when you retire than you are now, you’d be better off making a contribution to a Roth than a traditional IRA,” says George Wells, president of Legacy of America, a wealth management firm. “If you think you’re going to be in a lower tax bracket once you are retired, it’s to your advantage to do the traditional IRA.”

Overall retirement savings and goals

Other considerations are the current state of your retirement savings, how much you think you’re going to be able to save and what types of savings you have.

If you have money in a traditional IRA and have a retirement plan at work, those sources of income will be taxed in retirement at ordinary rates, leaving you with less income from the distributions from those plans, says Charles Cohn, a financial adviser with AXA Advisors in New York.

If you haven’t saved a lot for retirement, you should consider a traditional IRA if that makes the difference between contributing or not contributing at all, says Wells. If you’re able to do without the deduction, contributing to a Roth makes sense because your contributions will go farther in retirement on a tax-free basis, says Featherngill.

If you have amassed a good-size nest egg and hope to leave money to your heirs, contributing to a Roth IRA versus a traditional IRA would be better, says Cohn.

Roth IRAs are an excellent estate-planning tool because designated beneficiaries can spread out the required distributions they must take from an inherited Roth IRA throughout their lifetime, says Cohn.

As such, passing on a Roth IRA to your heirs is a powerful gift, because inherited funds can grow over a long period of time.