Todd Kading, CFP®, ChFC®, RF™

Miranda,

Here is a guide to each type of IRA.

Roth IRAs

They are tax-favored financial vehicles that enable investors to save money for retirement. They differ from traditional IRAs in that taxpayers cannot deduct contributions made to a Roth. However, qualified Roth IRA distributions in retirement are free of federal income tax and aren’t included in a taxpayer’s gross income. That can be advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.

A Roth IRA is subject to the same contribution limits as a traditional IRA ($5,000 in 2012). (The maximum combined annual contribution an individual can make to traditional and Roth IRAs is $5,000 in 2012.) Special “catch-up” contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits.

Another way in which Roth IRAs can be advantageous is that investors can contribute to a Roth after age 70½ as long as they have earned income, and they don’t have to begin taking mandatory distributions due to age, as they do with traditional IRAs; however, beneficiaries of Roth IRAs must take mandatory distributions.

Roth IRA withdrawals of contributions (not earnings) can be made at any time and for any reason; they are tax-free and not subject to the 10% federal income tax penalty for early withdrawals. In order to make a qualified tax-free and penalty free distribution of earnings, the account must meet the five-year holding requirement and you must be age 59½ or older. Otherwise, these withdrawals are subject to the 10 percent federal income tax penalty with certain exceptions which include death, disability, medical expenses in excess of 7.5 percent of adjusted gross income, higher education expenses, and to purchase a first home (up to a $10,000 lifetime cap).* However, these withdrawals would be subject to ordinary income tax.

Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes.

Traditional individual retirement accounts (IRAs) can be a good way to save for retirement. If you do not participate in an employer-sponsored retirement plan or would like to supplement that plan, then a traditional IRA could work for you.

Traditional IRA

This is simply a tax-deferred savings account that is set up through an investment institution and has several investing options. For instance, an IRA can include stocks, bonds, mutual funds, cash equivalents, real estate, and other investment vehicles.

One of the benefits of a traditional IRA is the potential for tax-deductible contributions. In 2012, you may be eligible to make a tax-deductible contribution of up to $5,000 ($6,000 if you are 50 or older). Contribution limits are indexed annually for inflation.

You can contribute directly to a traditional IRA or you can transfer assets directly from another type of qualified plan, such as a SEP or a SIMPLE IRA. Rollovers may also be made from a qualified employer-sponsored plan, such as a 401(k) or 403(b), after you change jobs or retire.

Not everyone contributing to a traditional IRA is eligible for a tax deduction. If you are an active participant in a qualified workplace retirement plan — such as a 401(k) or a simplified employee pension plan — your IRA deduction may be reduced or eliminated, based on your income.

For example, in 2012, if your modified adjusted gross income (AGI) is $58,000 or less as a single filer ($92,000 or less for married couples filing jointly), you can receive the full tax deduction. On the other hand, if your AGI is more than $686,000 as a single filer ($112,000 for married couples filing jointly), you are not eligible for a tax deduction. Partial deductions are allowed for single filers whose incomes are between $58,000 and $68,000 (or between $92,000 and $112,000 for married couples filing jointly). If you are not an active participant in an employer-sponsored retirement plan, you are eligible for a full tax deduction.

Nondeductible contributions may necessitate some very complicated paperwork when you begin withdrawals from your account. If your contributions are not tax deductible, you may be better served by another retirement plan, such as a Roth IRA. (The maximum combined annual contribution an individual can make to traditional and Roth IRAs is $5,000 in 2012.)

The funds in a traditional IRA accumulate tax deferred, which means you do not have to pay taxes until you start receiving distributions in retirement, a time when you might be in a lower tax bracket. Withdrawals are taxed as ordinary income. If taken prior to age 59½, withdrawals may also be subject to a 10% federal income tax penalty. Exceptions to this early-withdrawal penalty include distributions resulting from disability, unemployment, and qualified first home expenses ($10,000 lifetime limit), as well as distributions used to pay higher-education expenses.

You must begin taking annual required minimum distributions (RMDs) from a traditional IRA after you turn 70½ (starting no later than April 1 of the year after the year you reach 70½), or you will be subject to a 50% income tax penalty on the amount that should have been withdrawn. Of course, you can always withdraw more than the required minimum amount, or even withdraw the entire balance as a lump sum.

Without knowing your total circumstances, I cannot give you specific advice on which is better for you, but now you have a good guide on the details of each.

Best wishes in your new life. Here are a few quick ideas to be considering.

1. Work out a personal budget and track your expenses. Often times new divorcees completely mismanage their budget because they are not used to the new income and expense level.

2. Don't make immediate and large purchases. Stay on budget and get used to the new lifestyle. Besides, you don't want to make an emotionally charged buying decision.

3. Carry sufficient insurance coverage. Making sure you have proper coverage will decrease your chances of needing emergency funds to cover unexpected health care costs or to replace household goods in the event of a problem.

4. For your scenario of being realtively young, keep expenses down and try to save any extra funds in a combination of your 401(k), Roth IRA, and brokerage/savings account.

5. Remember that you probably received a share of retirement benefits during the divorce and you may be able to claim a portion of your spouse’s social security benefits once you are eligible for benefits.

Jim,

Here is info from the State of Texas ERS system. This may differ in your state.

"If you are an active employee, you may purchase Additional Service Credit (ASC) if you have at least 10 years of actual ERS service credit (not counting military service). ASC can advance your earliest retirement eligibility date and/or increase the value of your standard annuity upon retirement. You must purchase all service for which you may be eligible, such as withdrawn ERS service, military service, etc., before you will be allowed to purchase ASC. Usually, ASC must be purchased in increments of one year; however, if you can use ASC to establish eligibility for an immediate retirement, you may purchase the necessary months rather than the full one-year increment. ASC is designed to be revenue neutral to the retirement system and as a result could be expensive to purchase. The cost of this service will change with an increase in your age, your salary, or your years of employment with the State. The maximum amount of ASC you can purchase decreased from 60 months (five years) to 36 months (three years) on January 1, 2006. Following are examples of how this new limit works: • If you purchased three years of ASC by December 31, 2005, you cannot buy more. • If you purchased four or five years of ASC by December 31, 2005, you can keep all of it, but you cannot buy more. • If you purchased two years of ASC by December 31, 2005, you can purchase one more year after January 1, 2006. You may purchase ASC or other service credit through rollovers from your Texa$aver 401(k) or 457 Plans, rollovers from other qualified plans or IRAs, or personal check or money order. You may purchase ASC or other service credit through rollovers from your Texa$aver 401(k) or 457 Plans, rollovers from other qualified plans or IRAs, or personal check or money order."

I would take the last paragraph to mean that you will not be able to deduct after-tax contributions toward buying back your time in the system. However, you could use IRA money if approved by the state. This could mean that you might be able to use pre-tax dollars to buy back the time if you already have the money in a pretax IRA account. I suggest consulting a tax professional for specifics in your area and in your particular pension plan.

Take care, Todd