Tax Help: The Advantages of Roth and Traditional IRAs

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When it comes to saving for retirement, it can be confusing.  Tax help and tax deduction advice is often conflicting.  My goal here is to clearly explain how some simple retirement accounts work.  There are several types of retirement accounts you can have, depending on your occupation and income level, so it’s really a broad subject.  Here I want to focus on the individual retirement account (IRA) options out there, since many taxpayers choose these account vehicles for retirement saving.  As for additional retirement account options (like a 401(k)), how much and when to save, and what to invest in, I’ll leave that alone for now.

The IRS gives most of us, depending on our income levels, an opportunity to invest $5000 a year in an IRA (or $6000 if you’re over 50 years old).  There are two basic types of IRAs you can open, a Roth IRA or a Traditional IRA (there are a few others, like SIMPLE IRAs, that I won’t get into here).  Both accounts have tax advantages, but in exchange for lower taxes you lose some freedom to withdrawal and spend the money you put in.  So the liquidity of your retirement savings is reduced, but so is your annual tax debt.  In this way, the government is trying to encourage you to save for your retirement.  Each IRA is different in exactly how it is taxed and they have different eligibility rules, so I’ll describe each one separately.  Note that you can open both accounts, but your $5000 annual limit is used up as you contribute to either account.  In other words, in total both your contributions to each account cannot exceed $5000.

Contributions to a Roth IRA are post-tax, meaning that the money you put into your account has already been taxed.  There is nothing special about this, as many of you do the same thing when you deposit your paychecks into a checking or savings account after income taxes have already been pulled out.  Once you put your money into the account, you have the same flexibility as any brokerage account in that can invest in just about anything you like: stocks, mutual funds, REITs, bonds, commodities, or you can even leave it in cash.  Now, the great thing about a Roth is that not only does the principal and earnings grow tax-deferred, but when you start withdrawing your money in retirement, no taxes are due!  This means all of your earnings are never taxed.  This is a huge tax advantage, especially if you can save at a young age and your earnings grow to be large.  A few other facts about a Roth you should know:

•  Contributions for a tax year are due by the due date of your tax return, NOT including extensions.

• You can contribute to a Roth without penalty in a given year if your adjusted gross income (AGI) is $116,000 or less for single filers.  Compensation for IRA purposes is working compensation, meaning the $116,000 total does not include things like interest, dividends, rental income, pension payments, annuities, partnership income, etc.  This limit does change some tax years, so be sure to check before contributing if you’re on the border.  If you made more than this and you still contribute, then your contributions are considered in excess.

• You cannot contribute to your IRA past age seventy and a half.  If you are older than this and contribute, your contributions are considered in excess.

• Excess contributions over $5000, if your AGI is too high, or you are older than 70.5 are subject to a 6% excess tax.

• You cannot withdrawal money from a Roth before age fifty-nine and a half.  If you take out money before this age, these withdrawals are subject to a 10% early distribution tax.  There are some exceptions to this, including: money for a first home, money for qualified education costs, money for medical insurance, and money for annuity contracts.

• You NEVER have to withdrawal money from your Roth IRA if you don’t need to.

     Now for your main alternative, the Traditional IRA.  This account gives you the option of deducting from your taxable income the amount you contribute.  Thus, you can put in pre-tax dollars into a Traditional IRA.  Like a Roth, your earning grow tax-deferred in this type of IRA, but the difference is that BOTH your earnings and the principal you put in throughout the years are taxed as income upon withdrawal. So in a Roth you pay your taxes first and enjoy no taxes later in life, while in a Traditional you can avoid paying taxes now but will have to pay these taxes upon withdrawal.  This is the fundamental difference between the two.  Now, just like a Roth, once you put your money into the account you have the same flexibility as any brokerage account in that can invest in anything you want, with some very minor exceptions.  Below are a few more facts you should know about a Traditional IRA: 

• Contributions for a tax year are due by the due date of your tax return, NOT including extensions.

• The phase out amount for being able to deduct your Traditional IRA contribution is an AGI of $63,000 for single filers and $169,000 for married filing jointly filers. Remember that compensation for IRA purposes is only working compensation, meaning the total does not include things like interest, dividends, rental income, pension payments, annuities, partnership income, etc. 

• You cannot contribute to your Traditional IRA past age seventy and a half.  If you are older than this and contribute, your contributions are considered in excess.

• Excess contributions over $5000 or you are older than 70.5 are subject to a 6% excess tax.

• You cannot withdrawal money from a Traditional IRA before age fifty-nine and a half.  If you take out money before this age, these withdrawals are subject to a 10% early distribution tax.  There are some exceptions to this, including: money for a first home, money for qualified education costs, money for medical insurance, and money for annuity contracts.

• You HAVE to withdrawal money from your Traditional IRA by April 1^st of the year after you turn seventy and a half.  I know that sounds like a confusing and random time, but that’s the IRS rule.  If you don’t make the required minimum withdrawal, you may be subject to a 50% excise tax on the amount not distributed.

Tax Help on the Schedule A for Itemized Tax Deductions

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The Schedule A, also known as the long form.  We hear about it from friends and family, especially during tax season.  You know, from people who tell you about what you can and can’t write off as a tax deduction on your personal income tax return.  We all want the tax help and advice to maximize our tax deductions and reduce our taxes.  To help out, I’d like to clear up some of the misconceptions floating around and make it clear to you what items you can deduct.  First I’ll give you a basic idea of what the Schedule A Form is and when to use it, and then, of course, some of the common write offs you can take.

Most individuals fill out a Form 1040 when preparing their taxes.  On this form, Line 40 is where you can do one of two things: either take a standard tax deduction or put the total tax amount from an attached Schedule A.  How do you know which amount to use?  The only way to know is to fill out a Schedule A and then compare the total you have there to your standard deduction. 

The standard deduction amount varies depending on your filing status and the tax year: in 2008 married filing jointly or qualifying widow(er) it was $10,900, head of household was $8,000, and married filing separately or single filer was $5,450.   If the total deduction shown on your Schedule A is less than this amount, you will pay less in taxes if you use your standard deduction.  In other words, use the standard deduction!

Generally speaking, those who own homes and pay large mortgages, those who have large medical bills, or those who incur a lot of business expenses not covered by their employer are the typical taxpayers I see who end up using a Schedule A.  For many other people, however, the standard deduction is larger and thus should be used.  The following are some common deductions and rules you should know as you fill out your Schedule A:

• You can deduct home mortgage loan interest on your main and second home.  Only the person who is liable for the loan can make this deduction, even if someone else is actually paying the mortgage. It also must be a home, as only interest on a land purchase isn’t deductible. 

• Equity line of credit loan interest is deductible.

• Personal property taxes, like for a home, are deductible if they are charged on a yearly basis and are based only on the value of the personal property.

• Transfer taxes are NOT deductible as real estate taxes.

• Qualified medical expenses in excess of 7.5% of your adjusted gross income (AGI) are deductible.  A few specific points I see often: lodging at a hotel during a surgery is deductible at $50 per night per person, the cost of home improvements for medical reasons is deductible minus the value increase in your home, and general health improvements (like a gym membership) are NOT deductible.

• Medical insurance premiums are deductible and are not subject to the 7.5% rule.

• Medicare A (covered under Social Security) is NOT deductible on Schedule A as a medical expense.

• State and local income tax is deductible.

• Qualified business expenses in excess of 2% of your AGI are generally deductible.  Meals while on business are only deductible 50%.

• Property losses can be deducted up to the portion not covered by insurance.  Disaster losses in a Presidentially-declared disaster zone are also deductible. 

• Charity contributions are deductible, but are limited to a maximum of 50% of your AGI.  There are many specifics when it comes to donations, so I advised you speak with a tax professional before you donate to make sure you document your gift correctly. One note: if you donate a car, you can deduct the smaller of the free market value of the car on the date of transfer or the gross proceeds from the sale of the car by the organization you donated to.

• Margin interest is deductible.

• Gambling losses are deductible only up to the amount of gambling winnings. 

• Personal bad debts are not deductible on the Schedule A because they are considered short term capital losses, and as such are limited to $3000 per year.  Any balance can be carried forward.