GH Plus Investing

Ever since the introduction of Roth IRAs in 1997, the debate over Traditional IRAs vs Roth IRAs has raged non-stop, and is likely to continue for as long as the choice remains. One thing is certain, the choice an individual must make between the two is not a simple one as the rules and requirements, and outcomes of each are different and it should rely heavily on their own personal circumstances. The best course is to gain an understanding of how each works and what sets them apart from each other.

Traditional IRA Basics

Traditional IRAs have been around for a long time, so most people are familiar with them. Established by Congress to encourage individual retirement savings, Traditional IRAs enable individuals to save for their future by making tax-deductible contributions of up to $5,000* that can be invested in a number of ways to accumulate a nest egg that isn’t taxed until it is withdrawn, presumably at a lower tax rate in retirement. Any withdrawals made prior to age 59 ½ also be subject to a 10% penalty unless certain requirements are met.

Roth IRA Basics

Contributions made to a Roth IRA are not tax-deductible but can be invested in the same way as a Traditional IRA and allowed to grow without current taxation. The biggest difference between the two is that, with the Roth IRA, distributions are not taxed, and, although they may be subject to the same early withdrawal penalty, there are provisions that allow for withdrawal of principle at any time without penalty.

Other Key Differences between Traditional IRAs and Roth IRAs

Eligibility

Traditional IRAs:

Anyone who does not currently participate in another qualified retirement plan such as an employer-sponsored plan is eligible to contribute to a Tradition IRA. Those who do participate in another qualified plan may contribute to a Traditional IRA if their income doesn’t exceed a certain amount which, for a single filer is $60,000 and joint filers $100,000.

Roth IRA:

Anyone can contribute to a Roth IRA regardless of whether they participate in another plan as long as their income doesn’t exceed a certain income range which for single filers is $95,000 and $110,000 and joint filers $150,000 to $160,000. The contribution limit is reduced once a person’s income enters the range and then is disallowed completely when it exceeds the range.

Distribution

Traditional IRA:

All distributions from a Traditional IRA will be taxed as ordinary income. Any early distributions are subject to a penalty unless they meet certain requirements such as: Recipient is deemed disabled and cannot work; funds are used as part of a down payment on a first-time home purchase; funds are used to pay for college expenses; or they are distributed based on a schedule of equal periodic payments for life.

Roth IRA:

All distributions received from a Roth IRA are tax exempt. Early distributions are allowed to the extent that they are from the principles which are drawn out before interest. Also, distributions cannot be taken until the 5-tax year hold period has been met, meaning, the initial contribution to a Roth has to be held in the account for at least five years based on when the contribution was actually made. The same early withdrawal penalty exclusions that apply to Traditional IRAs apply to Roth IRAs.

Minimum Distribution Rules

Traditional IRA:

Distributions must commence by age 70 ½ and be sufficient to pay out the total balance by life expectancy.

Roth IRA:

There are no minimum distribution requirements.

Estate Taxation

Traditional IRA:

Distribution to beneficiaries are included in the estate for estate tax purposes, and they are also taxed to the beneficiary as ordinary income.

Roth IRAs:

Also included in the estate but not taxed to the beneficiary.

Which is Best?

While the Roth IRA holds some clear advantages over the Traditional IRA in terms of eligibility and distribution flexibility and taxation, the answer still lies in which one is best for your particular situation. For most people, the Roth IRA is likely to produce the best outcome. For example, a person who begins contributing at the age of 37 and is in a combined federal and state tax bracket of 33%, would generate about $700 more monthly income from a Roth than an IRA (assuming an 8% average return on investment and a 15% tax bracket after retirement).

Should I Change to a Roth?

If you have a Traditional IRA and are considering changing or converting it to a Roth IRA, you should be aware that the conversion will trigger a taxable event, which could impact the ultimate outcome. The amount of money that your move from a Traditional IRA into a Roth in excess of your principle will be taxed in the year of the conversion at your ordinary income tax rate. The tax can be paid directly from your IRA or with funds that you have available elsewhere. Either way, it will have the effect of diminishing your long term returns.

An alternative to consider is to simply cease making contributions to your Traditional IRA and start making them to a Roth. The only problem is that you will then have two different IRA accounts which can be more troublesome to administrate.

Summary

With all of the moving parts of both a Traditional IRA and a Roth IRA and the difference of each, it would be important to compare both with careful consideration of your current and future financial needs. Your best advice is to run some comparison using any number of IRA calculators available online that will help you determine which will produce the best outcome at retirement.

*Current limit for IRA contribution. Future limits will be indexed or increased by increments of $500

When it comes to deferred annuities, most people might classify themselves as “dummies” if only for the fact that they are fairly unique in the realm of investment products.  While the basic concept of a deferred annuity is simple – In exchange for a deposit of funds from an investor, a life insurer promises to credit a competitive rate of interest over the phase period and then guarantee a lifetime income payout during the distribution phase – there are a lot of moving parts within an annuity contract to make sure that all of that happens.  Herewith is an explanation of deferred annuities for dummies.

The Basic Premise of Deferred Annuities

An annuity is a legal contract issued by a life insurance company because it is a form of insurance protection.  Instead of insuring against the risk of dying too soon, and annuity insures against the risk of living too long. In other words, by contract, a life insurance company will guarantee that you cannot outlive your principal.

Annuities have existed for thousands of years as binding contracts between a private or government entity and individuals wherein a promise to pay the individual annual payments for a specified period of time, or a lifetime, was made in exchange for lump sum deposit of money. The purpose of the modern annuity, a product of life insurance companies originally offered in the 19^th century, evolved so that it could also be used to accumulate funds prior to the need for income.  These became known as “deferred” annuities because the income was to be deferred until a later time.

How a Deferred Annuity Works

A deferred annuity is comprised of two distinct phases: An accumulation phase which begins once the annuity owner’s funds are on deposit with the insurer; and a distribution phase which begins once the owner annuitizes, or converts a lump sum of money to an income stream.

Accumulation Phase

The key components of the accumulation phase are the accumulation account, a credited interest rate, a minimum rate guarantee, withdrawal provisions, and the death benefit.

Accumulation account:

Each annuity contract creates an account in which an investor makes a deposit and the funds accumulate.  Although the account is established in the name of the annuity owner, the funds become a part of the life insurer’s general account which is invested in secure vehicles such as long term government bonds.

Credited interest rate:

In return for the lump sum deposit, the life insurer credits the account with a fixed rate of interest.  In some deferred annuities, the rate of interest is guaranteed for a certain period of time, after which it is adjusted to the prevailing rates at the time or a minimum rate whichever is higher. The insurer generally credits a rate of interest that is based on the yield it generates from its own investment portfolio and the rates are typically higher than those found in bank CDs and other short term fixed vehicles.

Minimum rate guarantee:

After the initial or guaranteed rate period, the insurer will adjust the rates according to a formula. Most deferred annuity contracts include a minimum rate guarantee which prevents the adjusted rate from falling below it.

Withdrawal provisions:

Deferred annuity contracts allow for an annual withdrawal of funds up to 10 percent of the account balance without incurring a charge.  The charge, known as a surrender fee, is based on a percent of the funds withdrawn that are in excess of 10 percent of the balance, and can range from 5 percent to 10 percent in the first year of the contract. Each year the fee declines by 1% until it eventually disappears, after which there are no more withdrawal fees.

Death benefit:

Because annuities are an insurance contract, they include a death benefit which pays a lump sum of the accumulated values or the principal whichever is greater to a designated beneficiary.

Distribution Phase:

The key components of the distribution phase are the lump sum of principal, the payout rate, and the refund option.

Lump sum of principal:

During the accumulation phase, the funds are left to accumulate until the owner has a need for income. The accumulated balance then becomes the principal amount that is annuitized for income. Once the principal amount is annuitized, converted to income, the annuity owner no longer has access to the principal and can only receive it back through the annuity payments.

Payout rate:

This is the rate at which the insurer will determine how much income can be generated from the principal amount. The insurer factors in the amount of principal that is repaid as part of the income payments, the length of the payout period – either a specified period of time or the life expectancy of the annuitant, a minimum interest rate, and the income ownership (single or joint life) to arrive at the rate which is then fixed for the life of the annuitant. The shorter the annuity period the higher the payout rate and the higher the amount of principal that is paid as part of the monthly payment.

Refund option:

A refund option can be selected that will pay a designated beneficiary all or a part of the remaining principal balance in installments over a specified period of time.

Tax Issues

Deferred annuities qualify under the Internal Revenue Code as retirement plans, and as such, they are afforded some of the same tax advantages as qualified plans such as IRAs.  Primarily, the funds that accumulate inside an annuity are not currently taxed.  They are taxed upon withdrawal as ordinary income. Contributions to deferred annuities are made with after-tax dollars unless the annuity resides inside of a qualified retirement plan.