Q.: I am 34. My wife is 33. We finally have some extra money for savings and want to put money in an IRA. I understand we can make contributions for 2020 in 2021. Is that right and which is better a Roth or regular IRA?
— Sam
A.: Sam,
You have until April 15, 2021, to make IRA contributions for tax year 2020. At your ages, you can each contribute up to $6,000 to a traditional IRA, a Roth IRA, or any combination of the two you choose. Both spouses do not need to work but the working spouse will need earned income of at least $12,000 for you to fully fund the two IRAs.
Whether a traditional IRA or a Roth IRA is a better choice depends on a number of factors.
The dominant factor for most people is tax rates. The essence of the tax strategy is to pay taxes when you are in lower tax brackets and avoid taxes when in higher brackets. I will use 2020 numbers for joint filers in this column. 2021 numbers are slightly higher for most items mentioned.
If you are in a low tax bracket now and anticipate you would be in a higher tax bracket when you would take distributions, a Roth IRA is an excellent choice, if you qualify. You would fund the Roth IRA with after-tax dollars and eventually take the money out tax-free when you were in that higher tax bracket.
On the other hand, if you are in a high bracket now and anticipate you would be in a lower bracket later, say in retirement, a deductible contribution to a traditional IRA is a good choice, if you qualify.
The tax rate that will apply to you for 2020 is determined with certainty when you prepare your tax return. The tricky part can be guessing what rate will apply in the future. It is not a matter of tax rates generally going higher. It is a matter of what rate will apply to you in the year you withdraw funds and whether that rate will be higher or lower than the current rate. Sometimes there is a clear answer, sometimes not.
Once you establish a preference based on your view of you current and future tax rates, you look to see if you qualify to make the contribution you desire.
Qualification to make a deductible contribution to a traditional IRA depends on income and whether you or a spouse are covered by a qualified plan like a 401(k). If neither you nor your spouse is covered under a plan, you can both can make deductible contributions to a traditional IRA as high as $6,000 each.
If you are covered and your joint Modified Adjusted Gross Income (MAGI) exceeds $124,000, your contribution is not deductible. A MAGI under $104,000 means a full deduction is available. In between $104,000 and $124,000 a deductible contribution of less than $6,000 is allowed.
The same restriction applies to your wife if she is covered by a plan. One the other hand, if only one of you is covered, the non-covered spouse cannot deduct their contribution if your joint MAGI is $206,000 or more, a full deduction is allowed if MAGI Is below $196,000, and a partial contribution is allowed if MAGI is in between $196,000 and $206,000.
If you are ineligible for a deduction, the best alternative is to contribute to a Roth IRA, if eligible, rather than make a nondeductible contribution to a traditional IRA. Neither type of account provides a deduction but when money is withdrawn from a traditional IRA some tax will result but distributions from a Roth IRA can be tax-free.
For married persons filing joint returns, you must have a Modified Adjusted Gross Income (MAGI) of $206,000 or less to make a direct contribution to a Roth IRA with the phaseout range running from $196,000 to $206,000.
If your MAGI makes you ineligible for a Roth IRA, you may still make a nondeductible contribution to a traditional IRA which can be a “back door” to getting money into a Roth IRA under certain circumstances.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner with Moisand Fitzgerald Tamayo. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.