Remember back when gas was $3.70, Jeremy Clarkson was still on Top Gear, and One Direction was a crappy five-member boy band instead of a crappy four-member boy band? 2014 seems so long ago for most of us, but for contributions to your IRA account that year is still alive. If you didn’t remember to contribute last year — or you were simply too strapped for cash at the time — you have until April 15 to make it happen regardless of whether or not you have already filed your taxes.
The Individual Retirement Account, or IRA, is a tax-advantaged account that helps you save for retirement. There are two different ways these accounts can be structured. The traditional type allows income to be invested pre-tax, meaning your taxable income is reduced by the amount you put into these accounts. It is then allowed to earn interest and dividends and also realize capital gains, all without generating a tax liability. However, once you start taking money out — typically during retirement — the withdrawals are taxed as ordinary income. This is otherwise known as a tax-deferred account.
The Roth type works the other way. You pay taxes on the income when you earn it, and then put that after-tax money into a Roth account. As with the traditional account there are no taxes on capital gains, dividends, or interest. The beauty of the Roth is that if you play by the rules the IRS leaves this money alone forever. When you start taking money out in retirement it is all tax-free gravy.
So which should you put money into? Well, the common wisdom is if you think you are going to be in a lower tax bracket at retirement you’d want to load up in the traditional type accounts today. If you are in a low tax bracket now but aspire to be quite wealthy in the golden years, a Roth is appealing. But knowing which of these will actually be the case is impossible. Maybe the future will be some utopia where income taxes have been eliminated (also known as pre-1913 America). More likely, though, taxes will be higher in the future.
Luckily we don’t have to waste too much time trying to see into the future. When it comes to IRAs, the IRS makes the decision pretty easy. This is because in 2014 the deductibility of traditional IRA contributions starts phasing out at a modified adjusted gross income of $60,000 for single filers and $96,000 for those that are married and filing jointly. These aren’t exactly high tax brackets, making the Roth the more attractive choice for most (consult your tax professional regarding your eligibility).
Another advantage of the Roth is that if you do need the money before retirement, you can withdrawal your contributions tax and penalty free. Keep in mind, though, any gains withdrawn will be subject to taxes and penalties. So if you contribute $5,000 this year and your account grows to $5,500 next year and you take all the money out, only the last $500 will be subject to taxes and penalties. While I wouldn’t encourage anyone to take money out of their retirement accounts prematurely, this feature makes putting money into a Roth IRA a little easier for those of us with a deep-rooted fear of commitment.
These are great investment vehicles, but sadly the IRS only lets you contribute $5,500 each year; $6,500 if the National Minimum Drinking Age Act of 1984 ruined that summer for you (age 50 or older). So do yourself a favor and don’t let your 2014 contribution go to waste. Fund your Roth IRA today.
