As you probably already know, there are two basic types of IRAs: the traditional IRA and the Roth IRA. With either one, the deadline for contributions for the 2020 tax year is May 17, 2021 (extended from April 15, 2021). There are no further extensions even if you obtain the regular “automatic extension” for filing your return.
It is important to know the similarities and distinctions for the two types of IRAs. For starters, the annual limit for contributions to either IRA for the 2020 tax year (or any combination) is $6,000. (It remains the same in 2021.) Plus, you can add another $1,000 if you are (or were) age 50 or over by the last day of the tax year, for a total of $7,000. There is no current tax on the contributions and earnings within any IRA.
Generally, you can contribute to an IRA if you have earnings or other compensation from a job. If you file a joint return and have taxable compensation, you and your spouse can both contribute to your own separate IRAs. Total contributions to both IRAs for the year may not exceed your joint taxable income, or the annual IRA contribution limit times two, whichever is less. However, the ability to contribute to a Roth IRA is limited or eliminated for certain high-income taxpayers. Here are the other main differences to keep in mind.
- Traditional IRAs: Contributions may be wholly or partially deductible. But deductions are phased out if your modified adjusted income (MAGI) exceeds a specified level and you (or your spouse if you are married) are an active participant in an employer-sponsored retirement plan. Therefore, for many individuals, no part of the contribution to a traditional IRA is tax-deductible.
When you receive distributions from a traditional IRA, you are taxed at ordinary income tax rates on the portion representing deductible contributions and earnings. In addition, you will have to pay a 10% penalty tax on withdrawals made before age 59½, unless one of the special tax law exceptions applies.
- Roth IRAs: As opposed to a traditional IRA, contributions to a Roth are never tax-deductible, regardless of your MAGI. But there is a potential payoff on the back-end that you cannot realize with a traditional IRA: Qualified distributions from a Roth in existence for at least five years are 100% tax-free. For this purpose, qualified distributions include withdrawals made after age 59½, those made or on account of death or disability or those used to pay qualified first-time homebuyer expenses (up to a lifetime limit of $10,000).
Other distributions are taxed at ordinary income rates under special “ordering rules.” Contributions are treated as coming out first, followed by conversion and rollover amounts and then earnings. Thus, even if you do not receive qualified distributions, part or all of the payout may be tax-free.
Due to the lure of tax-free distributions, you might consider converting some or all of the funds in your traditional IRA to a Roth IRA. But be aware that the conversion itself is taxable at ordinary income rates just like a withdrawal. Also, if you must use funds being transferred to pay the resulting conversion tax, it will dilute some of the tax benefit.
Which type of IRA is best for you? It depends on a number of variables, such as your current and future expected tax rates, as well as other personal circumstances. Rely on your JMF Pension professional advisors for guidance.