welch julie 16Roth IRAs are similar to traditional IRAs in that the earnings in the account grow tax-free. However, they are different from traditional IRAs in that generally any withdrawals made will be completely tax-free. Also, unlike other IRAs, contributions can be made to a Roth IRA after a person is 70 ½ as long as that person earned income, such as earnings from a job.

The maximum annual contribution that can be made to all IRAs is $5,500 ($6,500 if the person is 50+). Thus, depending on income, an annual contribution could be split between a Roth IRA, a regular IRA and a nondeductible IRA.

The maximum contribution to a Roth IRA phases out based on adjusted gross income (AGI) as follows:

2016 Full Roth Partial Roth No Roth
Married filing jointly <$184,000 $184,000 - $194,000 $194,000+
Single/head of household <$117,000 $117,000 - $132,000 $132,000+
Married filing separately $0 $0 - $10,000 $10,000+

 

You and your spouse both work. You file jointly and have a combined AGI of $100,000 for 2016. Each of you participates in your employers’ retirement plans. You are eligible to make contributions to Roth IRAs of up to $5,500 each.

If your combined AGI is $189,000, you could make Roth IRA contributions of up to $2,750 each (since $189,000 is halfway through the phase-out range). You could also make nondeductible IRA contributions of up to $2,750 each.

Contributions made to a Roth IRA cannot be deducted. However, qualified withdrawals from a Roth IRA are both taxfree and penalty-free.

To be a qualified withdrawal, a taxpayer must meet certain conditions. First, a five-year holding period must be met. The five-year period begins on the first day of the year for which a contribution is made. For example, if a contribution to a Roth IRA is made on April 15, 2016, for the 2015 tax year, the fiveyear holding period would be met beginning in 2020.

Second, the withdrawal must be for one of the following reasons:

• The taxpayer is at least age 59 ½.
• The taxpayer dies and the distribution is made to a beneficiary.
• The taxpayer is disabled.
• The taxpayer is a first-time homebuyer.

If a taxpayer withdraws money from his or her Roth IRA and it is not a qualified withdrawal, some or all of the amount may be taxable to the taxpayer. However, the taxpayer may meet an exception to the early distribution penalty.

You are in the 34% (28% Federal and 6% state) tax rate bracket. You earn 10% (6.6% after tax) (10% x (1 - 34%)) on your investments. You make $5,500 contributions at the beginning of the year for 20 years to the following accounts. SEE CHART A

 

CHART A - 28% Federal Tax Roth IRA Traditional
Deductable IRA
Traditional
Nondeductable IRA
Taxable Account
Annual Contribution $5,500 $5,500 $5,500 $5,500
Tax Savings ($5,500 x 34%)   1,870    
Cumulative contributions 110,000 110,000 110,000 110,000
Account value - Year 20 346,514 346,514 346,514 230,115
Tax on distribution:        
   ($346,514 x 34%)   (117,815)    
   (($346,514 - 110,000) x 34%)     (80,415)  
Net cash from tax savings including interest earned   78,239    
  $346,514 $306,938 $266,099 $230,115

 

CHART B - 15% Federal Tax Roth IRA Traditional
Deductable IRA
Traditional
Nondeductable IRA
Taxable Account
Annual Contribution $5,500 $5,500 $5,500 $5,500
Tax Savings ($5,500 x 34%)   1,870    
Cumulative contributions 110,000 110,000 110,000 110,000
Account value - Year 20 346,514 346,514 346,514 230,115
Tax on distribution:        
   ($346,514 x 21%)   (72,768)    
   (($346,514 - 110,000) x 21%)     (49,668)  
Net cash from tax savings including interest earned   78,239    
  $346,514 $351,985 $296,846 $230,115

 

Thus, if your tax rate stays the same for all 20 years, and if you have a choice between the above accounts (based on your income level and your participation in a retirement plan), your first choice would be to make your contributions to a Roth IRA.

However, if your tax rate decreases after you retire, a traditional deductible IRA may be better. Assume your Federal tax rate drops to 15% (21% including the 6% state tax rate) in year 20 when you withdraw the money. SEE CHART B

In this case, your first choice would be to make your contributions to a traditional deductible IRA.

Additionally, a taxpayer may be eligible for the “saver’s credit” if he or she makes a contribution of up to $2,000 to their IRA.


Julie Welch (Runtz) is the owner of Meara Welch Browne. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri- Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.