Today I’m going to be examining traditional IRAs and Roth IRAs and trying to determine which one is actually better. Or at least which one would be better for various situations. Because as regular viewers of this channel will know my favorite answer of all time is it depends. Because in the personal finance Realm, a ton of your decisions will depend on your own specific situation.
And that includes the answer to the question of which type of IRA is right for you. Now I’ve noticed online that there’s a lot of bits and pieces of information out there but nowhere that I could find where you get the whole list of differences in one place. So I’m going to make this video that place. In this video, I’m going to be going really in-depth into the differences between the Roth IRA and the traditional IRA. But before I get into the differences between the two I want to briefly touch on the ways that they’re both the same. Let’s get started. Both the traditional and Roth IRAs can be contributed to by minors and non-working spouses as long as they meet certain special income rules.
The deadline for making contributions is April 15th. And under most circumstances, as long as you have enough earned income, the amount that you can contribute each year is $5,500 if your under the age of 50 and $6,500 if you’re over the age of 50. And earned income is basically wages, salaries, and tips in most cases. However things like union strike benefits, or in some cases long-term disability Benefits, and self-employment income in some cases is also considered to be earned income by the IRS. However things like interest and dividends or social security or alimony or child support are not considered to be earned income.
I also want to take a moment to talk about MAGI, because a lot of what Im going to talk about later wont make sense without it. So how do you find out what your MAGI is? Well thats really a two-part question because in order to find your MAGI you first have to find your adjusted gross income. And your adjusted gross income to put it simply is basically your gross income or the amount of money you make in a year minus any deductions that you’re able to take on your tax return which can include IRA contributions, student loan interest, tuition and fees, HSA contributions, and many other things besides.
And once you’ve got that number you have to add back in some of those deductions you took out to get your adjusted gross income to get your MAGI. Now in many cases, in fact in most cases, your AGI and MAGI will actually be identical. However, Ill put a few things up on the screen, and if you deducted any of those things on your tax return you would need to add them back into your AGI to find your MAGI. So with that out of the way what are the differences between these two IRAs? The first thing that everyone brings up when talking about the differences between these two types of IRAs is the differences in tax treatment.
In a traditional IRA you can deduct some or even all of your contribution on your tax return, whereas with a Roth IRA you cant. However one thing that people often fail to mention when talking about the tax treatment of a traditional IRA is that while in most cases you can deduct contribution, there are some exceptions to that deduction rule. For example if you’re married filing jointly on your tax return and your spouse is covered by a retirement plan at work and, as a couple, your MAGI is more than a $186,000 in 2017 but less than $196,000 you can only take a partial deduction on your tax return.
And if your MAGI is over $196,000, you actually can’t take any deductions. And this is the case even if you yourself are not covered by a plan at work. Now if you’re the one that’s covered by a retirement plan at work instead of your spouse the rules are slightly different. If you’re single or filing as head of the household and you make between $62,000 and $72,000 a year you can claim a partial deduction but if you make more than $72,000 then you can’t actually deduction that year.
If you’re married filing jointly or you’re a qualifying widow or widower, then you can claim a full deduction as long as you make $99,000 or less. If you make more than $99,000 but less than $119,000 then you can claim a partial deduction. And of course, anything more than that will stop you from claiming any deduction. And of course you can’t deduct your contribution for a Roth IRA, that’s really the heart of the difference between the two. Roth IRAs are taxed now but can be pulled out tax-free later, whereas a traditional IRA is usually tax-deferred now but then it would be taxed later when you pull the money out. A couple of other differences between the two plans is the ages at which you can actually contribute to the IRAs. For a Roth IRA you can actually contribute at any age however for a traditional IRA you have to be under the age of 70 and a half in order to contribute. Another difference between the two is how much you can actually contribute, and I don’t mean the contribution limits per year, under normal circumstances they’re both the same in that respect like I said before.
No, I’m referring to some other contribution limitations on Roth IRAs. You see in 2017 if you’re filing as single or head of the household and your MAGI is more than $118,000 but less than $133,000 then you can only contribute a reduced amount and I will give an example here in just a second. And of course if your MAGI is over 133k then you can’t contribute anything to the Roth IRA. If you’re married filing jointly or a qualifying widow or widower making between $186,000 and 196,000 a year you can contribute A reduced amount and anything above that you can’t contribute anything. With one exception known as the backdoor Roth IRA which is basically where you contribute money to a traditional IRA but then convert it to a Roth IRA. Now in order to figure out how much you can contribute to a Roth IRA (assuming youre not going to use the backdoor method) Im going to use an example. Let’s say that Bob is a single 45 year old lawyer whos doing pretty well for himself with a MAGI of $120,000 per year.
As a result he does fall in between the 118k and 133k limits for a reduced contribution to the Roth IRA. How does Bob figure out how much he can put in? First he has to start with his modified adjusted gross income and then because he is filing as a single he must subtract 118k (it would be 186k if you were married filing jointly). This leaves him with $2,000. He must then take that divided by $15,000 (or $10,000 if he were married filing jointly). Why? I don’t know it’s just how the laws work.
But that leaves him with 0.1333 and so on. He must then take that and multiply it by his contribution limit. Which since he’s 45 years old would be $5,500. If he were over 50 years old it would be $6,500. But he’s not so .133 times $5,500 leaves Bob with $733.33. And then the last step for Bob is to take his contribution limit of $5,500 and subtract the $733.33. This leaves him with his reduced contribution limit for the year at $4,766.67. The next difference is penalties. If you have a Roth IRA you will not pay penalties for withdrawals taken before the age of 59 and a half as long as long as those withdrawals are not more than the total amount you’ve contributed yourself to the IRA. So say if Bob from earlier had invested $5,500 a year into his IRA for the last 10 years he would have contributed a total of $55,000 and he could now take up to that $55,000 out without incurring any penalties. However if he took any more than that you would be hit with the 10% Federal penalty tax on the withdrawal of earnings.
So say he had a few huge medical bills and withdrew $60,000 from his Roth IRA. He wouldnt get penalized on the first $55,000 that he took out because they were his own contributions, however on the last $5,000 he would be hit with a 10% penalty or $500. Whereas in a traditional IRA there’s a 10% Federal penalty tax on withdrawals of both the contributions that you withdraw and the earnings before the age of 59 and a half. But of course it’s finance so there’s always an exception. And in this case your withdrawals may not be subject to the penalty tax if it’s due to any of the following reasons you see on your screen. Yeah Finance laws are unnecessarily complicated sometimes. The next difference between the two types of IRAs is that the Roth IRA has no required minimum distributions, but you must take a certain amount of money out of your traditional IRA starting on April 1st of the year following the year you reach age 70 and a half. So for example if your 70th birthday is may 20th, then you will be 70 and a half years old in November of this year meaning you would need to take a required minimum distribution from your IRA the following April 1st.
And then for every year after that you need to take it by December 31st. The amount of the required distribution varies depending on your life expectancy. The last thing that I want to talk about is inherited IRAs. Now there are three ways to inherit an IRA if you’re the account owner’s surviving spouse. You can either do what they call assuming the IRA as long as you’re the only beneficiary on the account. And basically how the IRS treats it if you choose this option is they assume that the IRA you received was yours all along. Which means that you can add your own contributions to it and if it’s a traditional IRA you won’t have to take any required minimum distributions until the year after you turn 70 and a half like we discussed before. The second option is to inherit the IRA. Which could have been named better I mean come on, why is it that if you inherit an IRA, inheriting the IRA is a term used for one of your three options.
They could have made that clear… Anyway inheriting an IRA basically means that you’re going to transfer the amount in the IRA you received into a different IRA that is in your name. Now if you do this you will have to begin taking the required minimum distributions in the year following the previous IRA owner’s death. Which can be good if the spouse needs money right away, but it also means that the IRA won’t grow quite as much because you’re no longer able to just keep letting it appreciate. The third and final option is to disclaim the IRA which basically means you just refuse to accept it either in part or in full.
But you’re going to really want to fully think through the ramifications before doing that because typically if you disclaim an IRA you can’t change your mind later. Now if you’re not the account owner surviving spouse, you can still either inherit the IRA or disclaim it, however if you choose to inherit it you must start taking the required minimum distributions right when you inherit it under these circumstances. But that’ll about do it for me I hope you enjoyed the video and if you did or if you learned something be sure to like And subscribe I’ve got a lot more of these Finance coming out in the near future as well as some more book summaries and other fun stuff. Also if you have any more questions about IRAs be sure to leave them in the comments and I will do my best to answer them. But with that being said, thanks for watching and have a great day. .