We live in a culture that craves instant gratification. Buy now, pay later. Our 24/7 world highly values immediate access to news, music, information – everything!
As a result, saving money (rather than spending money) can be a hard sell, particularly in tough economic times.
When choosing to establish an IRA and invest for the long term, many family child care providers are attracted to a Traditional IRA because of the tax deduction that is available today.
Enter the Roth IRA.
Let’s review the basic differences between a Traditional IRA and Roth IRA.
- A Traditional IRA gives you a tax deduction for your contributions. A Roth IRA does not.
- With a Traditional IRA, you will pay taxes on the withdrawal of your contributions and earnings. With a Roth IRA, all withdrawals are tax-free.
Although, in the long run, a Roth IRA is more beneficial than a Traditional IRA (in most situations), it can be hard to give up a tax deduction this year for a bigger reward in the future. It’s not always easy to delay gratification, even if we know it’s good for us. See also my article: “Traditional IRA or Roth IRA?”
Spouse and Children
An often overlooked benefit of the Roth IRA is the added flexibility of providing financial assistance to your spouse and children.
Let’s look at the advantages of a Roth IRA to your family.
- You can withdraw contributions tax-free if they are held within the Roth IRA for at least five years. This allows you to use the money for family emergencies, a college education for your child, or to financially help your child or grandchild in other ways.
- You can withdraw up to $10,000 in earnings tax-free if you use the money to buy a principal residence as a first-time buyer. The buyer can also be your children or grandchildren. (The child or grandchild must not have owned a home in the previous 24 months.) Thus, you can take out $10,000 to help with a down payment that will help reduce the financial burden of home ownership for family members.
- You don’t have to take out mandatory withdrawals after reaching age 70½ (unlike the Traditional IRA). This allows you to continue earning interest tax-free for as long as you want. You can later decide to donate your Roth IRA to your children or grandchildren.
- If you do pass on the assets in your Roth IRA to your spouse and children, they will owe no taxes on the contributions or earnings (assuming the Roth IRA has been established for at least five years).
- If your estate is large enough to owe estate taxes, a Roth IRA can reduce estate taxes, leaving more money for your heirs.
Nothing beats a Roth IRA for the potential benefits it can provide to your family.
There is a disadvantage, however, to a Roth IRA versus a Traditional IRA that could affect your decision to set one up and make contributions each year.
Contributions to a Roth IRA do not reduce your adjusted gross income on your tax return. This could be important if your income is close to qualifying for the full amount of tax credits such as the Child Tax Credit and the Earned Income Credit.
For example, let’s say you are married with two children. You may be eligible for a Child Tax Credit of $1,000 per child depending on your income. If you are married, filing jointly and your family’s adjusted gross income was $110,000 ($75,000 if you are single) or less, you will receive the full credit. However, for every $1,000 of income above this amount, you will lose $50 of this credit.
So, if your family’s adjusted gross income in 2014 is $115,000, you would be entitled to a $1,750 credit ($2,000 maximum credit – $250 [$50 x 5]). Claim the credit on Form 1040, line 51.
If you decided to contribute $5,000 to a Traditional IRA, this would reduce your adjusted gross income to $110,000 and you would receive the full credit of $2,000. If you contributed to a Roth IRA, your adjusted gross income would not change and you would lose $250 of this credit.
You will receive a lower Earned Income Tax Credit if you are married filing jointly and your family’s adjusted gross income is greater than $43,941 with one child ($38,511 if you are single).
All of the income eligibility numbers above are for 2014.
So, watch out for these income eligibility limits before making the decision to contribute to a Roth IRA.
The Roth IRA is a wonderful tax tool that rewards you for putting off a tax benefit today for a greater one tomorrow. As we have seen, it also can be used to provide tax-free benefits to your spouse, children and grandchildren. Delaying gratification has never been more rewarding.
See also my article: “What is a Roth IRA?“
Tom Copeland – www.tomcopelandblog.com
For more information about a Roth IRA, see my book Family Child Care Money Management & Retirement Guide.