It’s never too early to get a head start on planning for next year’s taxes. One strategy to reduce your tax liability may be to contribute to a traditional IRA or a Roth IRA. Both of these savings tools have unique advantages.

What factors should you consider when deciding which one to contribute to?

What’s the difference?

Contributions to a traditional IRA are made on a pre-tax basis. When you make a contribution on a pre-tax basis, this reduces your taxable income. For example, if I made $30,000 in 2015, and contributed $5,500 to my traditional IRA, my taxable income would be $24,500 come tax time. Contributing to a traditional IRA may help you move to a lower tax bracket for the rest of your taxable income. When money is withdrawn at retirement, the distributions will be taxable at your ordinary income tax rate.

When you make contributions to a Roth IRA, your contributions are considered to be after-tax. Using the same example, if I made $30,000 in 2015 and contributed $5,500 to a Roth IRA, my taxable income is still $30,000. Rather than getting a tax advantage when you deposit money, a Roth gives a tax advantage when you withdraw your money. Earnings and qualified distributions from a Roth IRA can grow tax-free.

Who qualifies and what are my limits?

Based on your income, you may not be able to deduct contributions made to a traditional IRA. For the 2015 tax year, if you are single, the income phase-out range for being able to deduct contributions to a traditional IRA is $61,000-$71,000 for singles; $98,000-$118,000 for those married filing jointly; and $0-$10,000 for those married filing separately. (Please click here to see how these rates have changed from the rates for the 2014 tax year—you’ll use the 2014 rates to file taxes in April 2015.)

For Roth IRAs, the phase-out involves whether or not you are eligible to contribute to a Roth IRA. In 2015, if you are single, the income phase-out is $116,000-$131,000; $183,000-$193,000 for those married filing jointly; and $0-$10,000 for those married filing separately.

The maximum you can contribute to an IRA or a Roth IRA is $5,500 per person in 2015. If you are over the age of 50, there is a catch-up provision that allows you to contribute an additional $1,000 each year. If you are married filing jointly, and only one of you works, you can still contribute to an IRA and/or Roth IRA for both you and your spouse.

Should I consider a Roth?

A Roth IRA makes sense for some people, as it gives you the ability to have a portion of your income withdrawn tax-free at retirement. This can provide you with an opportunity to employ tax planning strategies in retirement that may help lower your taxable income.

If you are young and have a long time before retirement, you can really capitalize on compounding interest by being able to withdraw money in retirement without any taxes. Although you aren’t saving taxes today, the benefits of compounding interest may allow you to have a good portion of your retirement income tax-free.

If you have done all of your savings to date on a pre-tax basis, it may make sense to build up the Roth bucket so that you can tax-diversify your retirement income. For example, if you have a traditional IRA you are distributing funds from, this money will be fully taxable at your income tax bracket in retirement. If I can pull a portion of my retirement income from the Roth bucket, and some from the pre-tax bucket, I will have a lower overall taxable income in retirement.

Finally, if you are looking to leave money to your children, the Roth money will go to your heirs tax-free. If it is in a pre-tax (traditional) IRA, your children will be taxed at their income tax rate when they take distributions.

Traditional and Roth IRAs are powerful tools to help you prepare for retirement. Work with your financial advisor and a tax specialist to determine if making pre-tax contributions or Roth contributions makes sense for your situation.

Adria Meehan Siewert

Adria Meehan Siewert

Senior Vice President, Financial Advisor

CFP ®, ChFC ®, AIF ®, Series 7 & 24 Securities Registrations,* Series 66 Advisory Registration,† Insurance License Having worked in the industry since 2007, Adria regularly meets with clients and works closely with the Roundtable™ team of specialists to develop financial plans that are specifically geared toward their values and retirement goals. She is involved in her Arlington Heights, IL community through Our Lady of the...Read More