Eliminate The Fog In Your Financial Forecast

Sometimes things aren't as they seem. Around twelve years ago I took a trip to Italy with my mother and son. We stayed with my son's friend in an old monastery that had been converted into apartments. Surprisingly it was really nice, and much larger than I had expected.

Right next door was an old church. A very, very old church. The history of our surroundings intrigued us. So one night after returning home from a long day of sightseeing, and viewing the church so majestically lit up, we decided to take some photos.

After snapping a few pictures I scrolled back through to see if I had captured the beauty I was actually witnessing. Wait! What...The...Heck?!?

I had multiple pictures showing what could only be described as a "hazy mist" between us and the church. We never saw it with our own eyes, just on the digital screen. So naturally I continued to snap away, all showing the same "hazy mist", but in different formations. 

I was sure we had captured something I could have sent in to Ghost Hunter's International, and probably would have posted all over Facebook if it had existed back then. We were shocked! We were excited! We ran back to the apartment with much enthusiasm to show our findings.

After telling the story, and showing our pictures, we all walked back over to the exact location we had captured these anomalies. As luck would have it, they were gone. Well until, in frustration, I lit a cigarette and snapped a few more shots. Mystery solved! My "hazy mist" ended up being debunked by my cigarette smoke.

Is a Roth or IRA best for you?

Sometimes figuring out things aren't as difficult as they seem. Take for instance the Roth IRA. Many people don't understand the differences between a Traditional IRA and a Roth IRA. Let me briefly explain...

The Traditional IRA deductions

When you contribute to a Traditional IRA, you may be able to claim it as a deduction (there are limitations for claiming deductions) from your taxes. Say you make $50,000 and contribute $5,500 (if you're 50 years old or under. For those over 50, you can do $6,500. These figures change from year to year, so check IRS.gov for the current amounts), it knocks your taxable income down to $44,500. That's the benefit...a lower taxable income now.

However, any contributions and earnings you make in the Traditional IRA are taxed upon withdrawal. Say you want to take out $5,000. You are taxed on the full $5,000 as income as it comes out. If you take it before the age of 59 1/2, you also get hit with a 10% penalty.

The Roth benefits

What about the Roth? Well, the immediate downside to making a contribution into it is that you don't get to take it as a deduction on your taxes. So why would you choose to "lock-up" funds into an account when it isn't offering you a tax break? Well, while the Traditional IRA contributors are getting their piece of cake at the beginning of the party, you're getting yours at the end...

By letting those contributed funds grow in the Roth, the earnings are growing tax-free. What kind of impact could this really make? Let's take a look...

Say you begin contributing to a Traditional IRA at age 25, making the full annual contribution limit until age 70. Over that 45-year span, you would have contributed a total of $267,500 ($5,500 until age 50, then $6,500 until age 70. Yes, I know the limits are expected to change, but they aren't as of yet).

Assuming a 6% annual return, a rough figure gives us about $1,355,000. When you take a distribution from a Traditional IRA you will be taxed on the full amount you take. Period.

If you contributed those same funds to a Roth, that $1,355,000 could be a tax-free nest egg! That's right, while you didn't get the tax benefit at the beginning, you are definitely getting it now. 

The limitations

There are some income limitation restrictions to the Roth, however. While anyone can contribute to a Traditional IRA, the IRS disallows Roth contributions for those making over a certain income. You can find the Roth income limitations here.

So what if you aren't eligible to make a Roth contribution, but really want to take part in the benefits of one? Well, there's always the Roth conversion. This is accomplished by converting Traditional IRA funds into Roth funds.

Using a conversion loophole

Using the conversion method will basically achieve the same outcome... Just make the contribution into the Traditional IRA, then complete the Roth conversion paperwork to move the funds over. As long as the contribution and conversion are both completed by December 31, you should be good. It may take a little more paperwork to accomplish, but could well be worth the time.

Sound too good to be true, like calorie-free bacon? You're correct. You better be fully prepared to pay the taxes that will be levied with the conversion. Since those Traditional funds already received a benefit (the income tax deduction), you can't double-dip. So just like that dreaded morning weigh-in after the weekend bacon bender, once the conversion is complete it's time to pay the piper.

While the Traditional IRA has some great current benefits, the Roth has some also, just later on. The one that fits your needs best depends on your particular situation.

Talk with a tax or financial expert about your specific situations. They can explain what you may qualify for, which one is right for you, and help you omit the "hazy mist" in your financial forecast.

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Disclaimer: In case I haven't made it clear...consult a tax specialist. I'm not one. I don't hold myself out to be one. Don't sue me~  The figures used here are by no means a performance guarantee.

"Image courtesy of  dan, published on 08 April 2011 Stock Photo - image ID: 10037072 FreeDigitalPhotos.net".