The answer to the question I’ve heard one hundred times / the differences between a Roth Individual Retirement Account (IRA) and a Traditional IRA.

Jerry Coon for The Rockford Squire writes: I have answered this question about one hundred times this last tax season and promised to write an article about it soon after April 15. The question concerned the differences between a Roth Individual Retirement Account (IRA) and a Traditional IRA. There has been much discussion about tax rates going up. My personal opinion is that unless our federal government figures out a way to stop spending over a trillion dollars more than it takes in every year, the rates inevitably will go up. Whether you are a Republican, a Democrat, a Libertarian, a Tea Party member, a Socialist, a Communist, or a non-partisan who belongs to none of the above, you have to agree that something is wrong in Washington DC. The federal government continues to grow while the rest of the economy either shrinks or barely grows in an overall sense. When reality ultimately sets in, and that may happen when interest rates are allowed to rise, those tax rates may also jump up. That’s when the differences between the Roth and the Traditional IRA will become important. Let’s go over those differences.

First, contributions to a Traditional IRA may be tax deductible. If deductible, the contributions will lower adjusted gross income (AGI) and that can be a distinct advantage. Most phase-outs of deductions and credits are based on AGI. By lowering AGI, more of a deduction may be allowed or more of a credit may be allowed. That can be a major factor in lowering a taxpayer’s final tax bill. Adversely, contributions to a Roth are never tax deductible. The amounts contributed to a Roth come from after-tax money while the amounts going in to the Traditional basically become pre-tax because they are deductible. The Traditional therefore gets its tax advantage up-front. Putting $5,000 into a Traditional today may get a deduction for $5,000 today. Putting $5,000 into a Roth today does not affect the tax return at all.

Second, the Roth gets its tax advantage later when withdrawals take place because withdrawals from a Roth generally are not taxable. Non-taxable withdrawals include the original $5,000 as well as earnings as long as the rules are followed. For example, the original $5,000 grows to $20,000 in the Roth. The entire $20,000 can be withdrawn on a non-taxable basis. Let’s see, $5,000 of the Traditional is not taxable up-front but the full $20,000 of the Roth is not taxable at the back-end when it comes out.

Third, at age 70 1/2, taxpayers must begin to take Required Minimum Distribution (RMD) withdrawals from the Traditional based on the taxpayer’s life expectancy. Currently, a person age 70 ½ is expected to live 27.4 more years. That translates to an RMD amount of 3.65%. If a taxpayer has $20,000 in his Traditional, he must take out 3.65% of the $20,000 or $730. At age 80, the taxpayer’s life expectancy is now 18.7 years so his RMD percentage has grown to 5.35%. If the IRA value is still $20,000, he would have to take out $1,070 to satisfy his RMD requirement. At age 99, life expectancy is still 6.7 and the percentage is 14.93%. The longer a person lives, the larger the percentage of the RMD becomes. That means, potentially, the higher the tax bill will be or may become. Conversely, the Roth has no such RMD provision. The taxpayer is not forced to take withdrawals. They would not be taxable even if taken but the taxpayer doesn’t have that RMD rule forcing withdrawals.

Fourth, Traditional IRAs can be passed on to beneficiaries but the beneficiary stands, tax-wise, in the place of the original owner. All distributions are taxable to the beneficiary just as they would have been taxable to the original owner. The beneficiary has some fairly stringent rules that must be followed when determining the length of time the beneficiary can take to get the money removed from the IRA. In the most lenient of cases, the beneficiary could take withdrawals over his/her lifetime. In the least beneficial of circumstances, 100% must be withdrawn by the end of five years after the date of death of the original owner. Which set of rules applies depends upon the relationship the beneficiary has to the original owner. A spouse usually is granted the most lenient distribution rules. A non-spouse person, such as a niece or nephew, may be able to take advantage of the lenient rules. A non-spouse, non-person such as an estate or trust, has the least beneficial rules applied to the distributions. Saying the rules are complex is an understatement.

There are some well-known IRA experts, such as Ed Slott, who make a very good living advising beneficiaries as to which set of rules must be applied to a certain set of beneficiaries. Beneficiaries of Roth IRAs have an easier go of it. The rules may force the beneficiary to take withdrawals but since the distributions are not taxable, it’s not as much of a factor. Roth IRAs are definitely worth looking at. This is Jerry Coon signing off.