With just a few days left before the New Year, I thought I’d put together a quick post on IRA contribution limits for 2012. As a reminder, contribution limits have been indexed to inflation since 2008, and can increase in $500 increments (as necessary). As you can see from the table below, however, nothing has changed in recent years.
| Year | Under Age 50 | Age 50+ |
| 2002-2004 | $3, 000/year | $3, 500/year |
| 2005 | $4, 000/year | $4, 500/year |
| 2006-2007 | $4, 000/year | $5, 000/year |
| 2008 | $5, 000/year | $6, 000/year |
| 2009 | $5, 000/year | $6, 000/year |
| 2010 | $5, 000/year | $6, 000/year |
| 2011 | $5, 000/year | $6, 000/year |
| 2012 | $5, 000/year | $6, 000/year |
A few notes…
First, note that this limit is a combined limit for traditional and Roth contributions. Thus, while you can contribute to both in the same year, the total contribution cannot exceed the $5, 000 (or $6, 000) limit.
Second, your traditional IRA contributions may be tax deductible, depending on whether or not you’re covered by a retirement plan at work, and how much money you make. Details can be found here and here.
Finally, remember that you can make contributions for 2011 all the way up to April 17th, 2012 (the due date for filing 2011 tax returns). Thus, if you still haven’t gotten around to it making your 2011 contributions, you still have time.
BG: I think I agree with investing in a traditional vs. Roth IRA, but in your example above did you take into consideration the accumulated earnings (hopefully) that will be in the traditional account?
BG: I will have to research this one! This is an area that wouldn’t affect me at the moment, so I had not looked into it. I will try to do so and post back some details.
Jonathan) If the government implements the “Fair Tax” in the future, then it is (you guessed it), still better to put one’s money into a traditional account today, if you are in the 25% (or higher) marginal bracket today. The fair-tax has the ‘income-equivalent’ tax rate at 23%.
Now, I have a question for you: if people have tons of money saved in Roth accounts, are you double taxed if the “Fair Tax” is implemented? Meaning: you paid income taxes on the Roth contributions already, would you have to pay the Fair-Tax’s sales-tax when you pull that money out to spend it? Again, another reason why to avoid paying as much taxes today as you can legally get away with (defer it all). And details like this is probably why the Fair-Tax will never be implemented (I think a federal sales tax is coming, but not a complete elimination of the income and payroll taxes).
If you are unfamiliar with the FairTax, please check it out!
http://www.fairtax.org/
Nickel) Let me give you an example on why I hate Roth accounts.
Assume you are in the 25% marginal tax bracket today. Any contributions you make to a traditional account avoids that 25% income tax (the tax is deferred and the future rate is NOT fixed). Any contributions made to a Roth account is taxed at your highest marginal tax bracket today (which we are assuming is 25%).
Now, fast forward to retirement. In retirement (just like today), you have a personal exemption ($3,800/person in 2012), and also a standard deduction (in 2012: $5,950/single, $11,900 MFJ). Note: the government does a decent job keeping these numbers tied to inflation. So, if you are married in retirement, you will have $19,500 worth of personal exemptions (2 people), and the “Married Filing Jointly” standard deduction. That $19,500 is ALREADY TAX FREE — because it is an exemption from your income subject to taxes.
That $19,500 should absolutely be taken from a Traditional account (401k or IRA). This way, you pay NOTHING in taxes on that money (no taxes on the contributions OR on the withdrawal). If you take that money from a Roth account, then you _needlessly_ paid taxes on the contributions for retirement income that wasn’t subject to income taxes anyway!!! (thank you for your donation to our government’s spending priorities).
After the above described “0%” tax bracket, you have the 10% tax bracket. Which is for the next $17,400 (married or $8,700 single). Would you rather pay 25% on Roth contributions today, or pay 0% today and pay a deferred 10% tax rate (on the next $17,400) at retirement? I’d go with traditional and avoid the 25% tax today and pay the 10% in the future on that next chunk of income.
So far, we have accounted for $36,900 in income (during retirement, MFJ) that is much better served by traditional accounts (if you are in the 25% marginal bracket today). Assuming a 4% withdrawal rate — you will need $925,000 in traditional retirement accounts just to fill the 0% and 10% brackets in retirement for the rest of your life.
Now, the next marginal bracket is 15%, which is the tax rate on the NEXT $53,300 of retirement income (married, or $26,650 single). Again, you do not want to pay a 25% income tax today (in Roth contributions), for money that will ONLY BE taxed at 15% in the future. Now we have accounted for $90,200 in yearly retirement income that is better served by traditional accounts (versus Roth) if one is in the 25% marginal tax bracket today. To be able to pull $90,200 in yearly retirement income using a 4% withdrawal rate requires just over $2.25 million saved up in traditional (not ROTH) accounts.
Most people can stop here — most of us will not see these numbers in retirement (just being a realist).
The next marginal income tax bracket in retirement, the 25% marginal bracket — it is a wash now. It makes no difference whether you pay the 25% today (using a Roth), or pay the 25% in the future (using the traditional account). Remember, it is only income OVER $90,200 that is even subject to the 25% tax rate in retirement — all the money less than $90,200 a year is still taxed at the lower 0%, 10%, and 15% brackets, which are better served by the traditional (NOT Roth) accounts. If you have $90,201 in yearly retirement income, then only $1 will be taxed at the 25% tax rate (all the rest were taxed less).
And for this 25% bracket, I say: pay it in the future, because once you pay the tax man — you can’t get it back — defer it (in a traditional account) for as long as you can!
Anyhow, the Roth only starts to look attractive for the retirement income that will be taxed at a higher rate, which is the 33% tax bracket in the future. In that case, it would be better to pay 25% today (in the Roth), to avoid the 33% future rate (that you would have to pay using a Traditional account). That 33% tax rate is reserved for yearly retirement income above and beyond $236,950. (All the money less than $236,950 is still taxed at 0%, 10%, 15%, and 25% rates).
You will need $5.9 million in TRADITIONAL retirement assets before even considering a Roth account (assuming the 4% withdrawal rate and you are in the 25% marginal bracket today).
Now, if you think Congress is going to raise rates, ask yourself this: are they going to get rid of personal exemptions and the standard deduction (the 0% bracket)? Are they going to abolish completely the 10% marginal bracket, and the 15% brackets? The only likely scenario is that they convert to a flat-tax.
If they convert to a flat-tax, do you think the flat-tax rate is going to be above (or below) the 25% marginal bracket we are assuming you are in today? If the flat-tax rate is less than 25%, then you guessed it, it is better to NOT pay 25% (by using a traditional account) today, and pay whatever the lower flat-tax rate is in the future. If you think Congress will pass a flat-tax with a higher than 25% tax rate in the future, then I got a bridge to sell you…
🙂
BG: What if rates skyrocket across the board? In that case, you could wind up in a lower bracket, but with a higher rate. For example, you could drop from the second lowest to the lowest bracket, but your rate then could be higher than your rate right now because rates could increase across the board. Not saying that this is (or isn’t) likely, just pointing it out as a possibility.
What if you have children, a startup business or some other means of deducting greatly from your taxable income. These deductions may not exist during retirement. Another scenario is semi-retirement or another situation where you need to take distributions while other taxable income is still rolling in. I’m with Nickel. I plan to diversify my tax exposure at least to some extent.
Jacob, you should call the IRS helpline. One would think you could undo the Roth account…
Nickel, good point. I’d use the Roth if I have already exhausted all the traditional options. As for hedging, it stol doesn’t make sense unless you have exhausted all the traditional options first. Even if we go to a flat tax, you want to be in traditional today…
BG & others: If you make too much to be able deduct your traditional IRA contributions, then the Roth is a great deal. Note that, due to income limits for contributing to a Roth, you’ll need to first make a non-deductible contribution to a traditional IRA and then convert it to a Roth. They abolished the income limits for converting awhile back so this works quite nicely.
Another argument in favor of the Roth would be that it helps you to diversify your tax exposure. Nobody really knows what will happen with tax rates (or the structure of our system) in the future, so putting some in tax-deferred (traditional IRA, regular 401k, etc) and some in Roth-type accounts could be viewed as a risk reduction maneuver.
Well, I’ve talked to my financial institution, I’m either getting the 10% early withdrawl or a possible 6% from the IRS for being too good with protecting my future. What a freaking joke. Anyone know how I can figure out if I’m getting hit with the 6% or not?
Ben) Good question, and one I don’t have a solid answer for. I don’t know any situation where the Roth IRA is the better choice (over traditional IRA), except:
* You are typically in a higher tax bracket, but find yourself in a lower one this year (slow year, or job loss?): then put the money into a Roth to lock in the (temporarily) low rate you find yourself in today.
Other than that, I think Roth is a waste of money unless you like donating extra dollars to the tax man. I lean very heavily toward traditional accounts (401k and traditional IRAs) because you avoid paying taxes at the highest marginal tax rate you are in today, and you are deferring paying those taxes until you are in retirement and will (very likely) be in a lower tax bracket.
In a nutshell: It is very hard (if not downright impossible) to save enough today, to be in a higher tax-bracket in retirement, to justify the Roth options.
I thought I could do 5k into each? Boy am I in trouble now.
it’s great you mentioned the tax deductibles from traditional IRA’s. If you are backed by your employers retirement benefits, it would be wise to invest the money into an Roth for a higher ROI and then roll over or convert to traditional to save on tax.
So, Roth or Traditional? There is an income line where one makes more sense, right? What is that line?
Good reminder! The $5,000 limit can seem out of reach, but even if you can’t max it out, every little bit helps! I made all of my investments automatic to take advantage of dollar cost averaging, and to take away the temptation to spend the money on something else!