Roth versus Traditional IRA – Steps to Setting Up a Tax Optimized Portfolio

As we earn our weekly or bi-weekly income, we have options on where we can place a portion of that income. Typically, most people would first pay off bills and then tackle debt. The rest is placed at a bank using an online bank or a brick and mortar bank. I have talked about the philosophy of paying yourself first and how that forces an individual to lower daily expenses. I have also talked about ways you can eliminate debt to get you going on your path to financial freedom. After the budgeting and debt situation has been sorted out, the next thing that comes to mind is “how can the inflow of cash be used to generate more cash?” This can be done using different avenues highlighted in a previous blog post.
Today, I will be focusing on the IRA and maybe the IRS (if you replace the “A” with an “S”). Jokes aside, the IRS is actually very important when discussing the IRA as there are rules that govern the taxation of your IRA. If you do not have an IRA (this is not your company’s 401(k) by the way), you can open one for FREE on M1 Finance. I have written a previous post on M1 Finance and why it is my favorite investment firm (which is no secret!). You can also transfer any existing IRAs to M1 Finance as well.
An IRA is an individual retirement account that allows an individual to save for retirement. The benefit of an IRA is mainly the tax advantage it provides which will be discussed in detail. The IRA contribution limit for year 2018 is $5,500 (and $6,500 if you are age 50 or older) while the new limit for year 2019 is $6,000 for those below age 50. The deadline to contribute to an IRA for the previous year is April 15 of the current year. IRAs can be opened in pre-tax (Traditional IRAs being the popular one) and after-tax accounts (Roth IRAs being the popular one). An IRA can contain stocks, bonds, index funds, mutual fund, and REITs. I do not recommend high cost funds as the fees could hurt your earnings in the long run. Now, let us get into the meat of today’s discussion “Roth vs. Traditional IRA – which is optimal from a taxation point of view.” A Roth IRA is taxed today but the earnings will grow tax-free. This makes a lot of sense for those who expect to be in a higher tax bracket when they take distributions from their Roth accounts. As opposed to the Roth IRA, a traditional IRA is not taxed today (you take deductions when preparing your taxes), however, you will be taxed in the future. Hence the traditional IRA offers an up-front tax break. Now, there are rules to the traditional IRA to be aware of, especially those with higher incomes. If you are covered by a retirement plan at work there is a limit on the amount of deduction you can claim when filing taxes. Below is a snapshot from the website of the IRS with the IRA deduction limits for year 2019 based on your modified adjusted gross income.
Once you get past $74,000 for a single or head of household, then you cannot claim a traditional IRA deduction on your 2019 taxes (this threshold is $73,000 for a single or head of household for 2018 taxes). Obviously without this tax benefit, contributing to a traditional IRA is put into question. Also, it should be noted that you cannot make contributions to a traditional IRA after you reach age 70.5 but you can make contributions to a Roth IRA after the age of 70.5.
There are eligibility rules that pertain to the Roth IRA as well. Below is a breakdown with the contribution limits for year 2019 from the website of the IRS.
You are not eligible to contribute to a Roth IRA for a single or head of household individual with an adjusted gross income greater or equal to $137,000. Those between $122,000 and $137,000 can contribute a reduced amount lower than the maximum and those with an AGI lower than $122,000 can contribute the maximum allowed for that year to a Roth IRA.
The IRA offers tax advantages available to everyone in the United States. The main benefit for a Roth IRA is the ability to grow any gains tax-free. This is especially beneficial for those who expect to be in a higher income tax bracket in the future when they take distributions. It is important to take advantage of either the traditional IRA or Roth IRA if you fall within the contribution and deduction limits as it provides a tool to achieving financial freedom.


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