After reading this amazing article on Roth IRA vs. Traditional IRA from MadFientist, I was convinced that Traditional IRA is the way to go. That’s why I recently opened Traditional IRA with LendingClub. As a financial investment newbie, that was a big step that I’m proud of. However, the conclusion that Traditional IRA gives your the best of two worlds is based on a few assumptions. After some digging, I realized that Traditional IRA may not always be a winner. Actually, there are some circumstances when Roth IRA will clearly be the winner, which was not covered in that article.
Assumption 1 – Tax-free contribution
Madfientist’s comparison is based on tax-free contributions to a Traditional IRA. It may apply to many people, and it’s often regarded as the biggest advantage of Traditional IRA, one has to keep in mind that in some cases only partial or even none of the Traditional IRA contribution is deductible in tax returns. In short, it depends on two factors:
a) Do you have a retirement plan at work?
b)If yes, does your Modified AGI (adjusted gross income) fall under the deduction threshold?
For question a), if your answer is no, then congratulations, you can have pre-tax contributions to your Traditional IRA account. Now you can skip to Assumption 2.
However, most people who have a full-time job though, will likely have some retirement plan at work, for example, e.g. 401k, 403b, etc. If that’s the case, we need to determine our answer to the second question – what’s your Modified AGI? Below is a screenshot from the IRS on how much of your Traditional IRA contribution can be deducted depending on your modified AGI for 2015.
As we can see from the table, if you are married filing jointly, with $98,000 or less Modified AGI, a full deduction is qualified. Great! But if $118,000 or more, sorry, no deduction. And partial deduction is available for those whose Modified AGI falls in between. For other filing statuses, certain Modified AGI requirements also need to met as shown.
These income limits listed are above national average, so most Americans would be able to enjoy a full or at least partial deduction with Traditional IRA.
However, if you unfortunately (or fortunately) fall into the category where you have no tax deduction from your Traditional IRA, then it makes no sense to contribute to Traditional IRA. In that case, Roth IRA is a way better option considering its tax-free withdrawal advantage upon retirement age. That is if your income qualifies you to contribute to Roth IRA, which you can find in this IRS page.
What if your income again disqualifies you for Roth IRA contribution? Well, first celebrate your financial success with a glass of champagne! Not that many people make that much money! Then, put that money in whichever account you like and invest it, just don’t put it in a Traditional IRA. [Read more…]