Most people have heard about Individual Retirement Account (IRA) plans which provide self-administered tax advantaged retirement saving options. For most people two types of IRA options are best – a Traditional IRA or a Roth IRA (see a comparison). But choosing the right option depends on a variety of factors that include, how much you and/or your spouse make, filing status and age. It can all get a bit confusing. Luckily I found a pretty good walk-through tool when looking at IRA options via E*TRADE. Here’s the key questions they ask that can help figure out which IRA account type is the best for you.
How old will you be at the end of the year?
The first question asked is how old you will be at the end of the year because your age determines your maximum contribution. The maximum contribution varies by filing status and has steadily been going up over time. Individuals 50 and over can make additional “catch up” contributions. If you are over age 70½, you are not eligible to contribute to a Traditional IRA, but can still make Roth IRA contributions.
Will you have earned income?
You must have earned income to make any type of IRA contribution. Earned income includes wages, salaries, tips, and bonuses. It does not include income from dividends, pensions, or annuities. If you have no earned income, you cannot open an IRA and the tool will tell you so.
In an employer-sponsored retirement plan?
Your eligibility to participate in an employer-sponsored retirement plan, such as a 401(k), 403(b), 457, Profit Sharing, or Money Purchase plan, may considerably impact your ability to deduct Traditional IRA contributions on your taxes. In fact if you already contribute to an employer sponsored plan, which gives you the same benefits as an IRA plan, a Roth IRA will normally be your only (and best) option. I would go as far to suggest that unless you are making the maximum contributions to your employer plan, you should not even consider a Traditional IRA.
Your tax-filing status is one factor in determining the amount you are able to contribute to a Roth IRA, or whether you could deduct a Traditional IRA contribution on your taxes. You can see these Roth IRA and Traditional IRA tables, which provide the breakout by filing status. Basically if you are married, your spouses income and retirement plans come into play when if comes to your contribution eligibility. Which is kind of annoying because an IRA plan can only be opened at an individual level yet is subject to joint conditions.
Combined estimated income for BOTH you and your spouse
As you and/or your spouse’s income increases, your ability to deduct a Traditional IRA contribution or contribute to a Roth IRA decreases. For example, if you are married filing jointly, your maximum Roth IRA contribution amount begins to decrease (phase out) when your income exceeds $173,000 and is eliminated altogether when your income reaches $183,000.
Your estimated income is your adjusted gross income (AGI) with a few modifications. Any income resulting from the conversion of a Traditional IRA to a Roth IRA is subtracted from your estimated income. Deductions taken for IRA contributions, qualified tuition, student loan interest, and exclusions for foreign housing, qualified bond interest, employer-paid adoption expenses, and domestic production activities are added back to adjusted gross income.
And the best option is….
After answering the above, the tool spits out the best option for you. For my choices above it was a Roth IRA, which is where I was leaning anyway. I maxed out my employer 401k contributions and given my household’s income levels a Roth IRA was probably the only choice for me. Still it was good to walk through this tool and verify this. You can walk through the tool your self at E*TRADE (you can see it when you start the account application process). I tried a few other combinations and got the following answers of note (assumed earned income in all scenarios). As you can see the choices vary a lot with circumstance.
- Scenario #1 – Age < 49, Yes to employer work plan, Single filing status, $111,000 estimated AGI (income). Best option is: A combination of a Roth IRA and a Traditional IRA is right for you. Your maximum contribution to a Roth IRA for 2012: $4,670. Your maximum contribution to a Traditional IRA for 2012: $330
- Scenario #2 – Age 50 to 70, Yes to employer work plan, Qualified Widower filing status, $165,000 estimated AGI (income). Best option is : A Roth IRA is right for you. Your maximum contribution for 2012: $6,000
- Scenario #3 – Age < 49, Has earned Income, No to employer work plan, Married filing status, Spouse eligible for plan, $99,000 estimated AGI (income). Best option is : You’re eligible for both a Traditional and Roth IRA. Choose the statement you agree with the most: I would rather take a tax deduction now, even if I have to pay taxes on my withdrawals later. (This would indicate if a Traditional IRA is right for you). OR I prefer to have tax-free withdrawals in the future, even if my contributions are not tax-deductible now. (This would indicate if a Roth IRA is right for you)
While E*TRADE is a great place to open and manage an IRA account, I suggest you also check out some other top online brokers for IRA account options based on what features (costs, fees, research, investor education) are the most important for you.