This is my first blog regarding income taxes.  I will try to post a blog each week regarding income taxes.  These blogs will focus on income tax laws, explaining the implications and ways to reduce your taxes with new and existing laws.  While I will try to help taxpayers at all income levels, one of my main concerns is the distortion caused by the media.  It tends to focus on the upper 20% of taxpayers.   It fails to point out if and how the changes affect the other 80%.  In some cases good advice for the 20% is bad advice for the 80%.  In short, each taxpayer needs to understand how the rules affect him or her.

The first issue I would like to address is the regular IRA verses the Roth IRA. This discussion will be limited to income tax characteristics of each and not which one you qualify to make a contribution to each year.  That will be another discussion.   I believe the Roth IRA and converting a regular IRA to a Roth IRA has been oversold.  This has resulted in taxpayers making contributions to a Roth when a contribution to a regular would have been more beneficial.   It has also resulted in them converting regular IRAs into Roths and incurring unnecessary taxes.  To understand the issues here are the main differences between the IRAs.  Regular IRAs are tax deductible when you make them and taxable when you take them out.  Roth IRAs are not tax deductible when you make them but are not taxable when you take them out. These assumptions assume the withdrawals are not subject to any early withdrawal penalties. It is basically a pay me now (Roth) verses a pay me later (regular) issue.  Another way of looking at this is that with the regular IRA you get a tax deduction currently, leaving you with more money to invest, and you will pay income tax on everything when it comes out.  With a Roth IRA you do not get a tax deduction, leaving you with less money to invest.  You do not pay tax on the earnings while the money is in the Roth IRA, and you do not pay tax on any withdrawals from the Roth IRA.  Comparing the two IRAs you are trading a current tax deduction with the regular IRA for not having to ever pay income tax on the earnings of a Roth IRA.

In determining which IRA is best for you, or whether you should convert your regular to a Roth the key factors are:

1) Your current age

2) Your current tax bracket

3) When you will start making withdrawals

4) What tax bracket you will be in when you make withdrawals

Here are the basic rules when making the decision between the 2 types of IRAs or a conversion.  Young favors Roth and older favors regular.  Based on my own calculations and reading, the breakpoint is generally somewhere in your 40s.

A lower current tax bracket and higher later tax bracket favors a Roth.  Do not assume you will be in a higher tax bracket later, especially if you are near retirement.  The media has failed to explain most of the changes in recent years and the coming Obama Care changes do not increase tax brackets for the majority of taxpayers.  Tax brackets have not gone up for the majority of taxpayers and the current scheduled changes do not affect most taxpayers’ tax brackets.

If you will need to start withdrawals soon, a regular IRA is probably better since you are keeping more of your money, and there may not be sufficient time to recover the tax loss with a Roth.

If you expect to be in a lower tax bracket when you retire, the regular IRA is usually better.  For example, if you are in 25% bracket today and will be in a 15% bracket when you retire, the regular IRA will save you 10% in taxes, and you have more money invested.  Again, watch the media hype on higher tax brackets.

There are a couple of other points to remember.  If you have a bad year and are in an unusually low tax bracket or have a negative taxable income, consider converting a regular IRA to a Roth since the tax you will pay will be lower or possibly none. If you can make a contribution to an IRA consider a Roth, especially if you are in a zero tax bracket.

If you convert a regular IRA to a Roth, remember you have to pay taxes, so be sure you have the money available outside of the IRA.  If you have tax withheld from the IRA during the conversion, it may be subject to an early withdrawal penalty.  The money withheld for taxes is coming out of a regular IRA and is not being transferred to a Roth, so if you are not over 59½ there probably will be a 10% penalty.

This is intended to give you some insights into the differences between IRAs.  Each taxpayer’s situation is different.  If you are in doubt what is right for you, get some unbiased professional help.

Jay Baxter