Are you facing divorce and trying to determine which assets to take? This can be a daunting task! This article is designed to help you understand the difference between Rollover/Traditional IRAs and Roth IRAs so you can make confident financial decisions during your divorce. There are two main types of IRAs: Rollover or Traditional and Roth. Let’s take a closer look at each.
Rollover or Traditional IRA
A Rollover IRA and a Traditional IRA are the same for tax purposes. A Rollover IRA means these funds were formerly a qualified account like a 401k and the money at some point was “rolled” into the IRA – thus, a Rollover IRA. A Traditional IRA is just an IRA, usually, which received direct contributions over the years. They are really one in the same from a financial planning perspective – and a Traditional IRA may also receive “rollovers” from a qualified plan (right, I know it’s confusing). In summary – just consider them to be the same.
With a Traditional IRA, you contribute pre- or after-tax dollars, and your money grows tax deferred. This means you won’t pay taxes on your contributions or earnings until you withdraw the money in retirement. However, when you do withdraw the money, you’ll pay taxes on the full amount as current income. Here are some key rules for traditional IRAs:
- Contribution limit: For 2023, you can contribute up to $6,500 if you’re under age 50, or up to $7,500 if you’re age 50 or older.
- Tax benefits: Depending on your income, you may be able to deduct your contributions on your taxes, which reduces your taxable income for the year. However, you’ll pay taxes on your withdrawals in retirement.
- Penalty for early withdrawals: If you withdraw money from your traditional IRA before age 59 1/2, you’ll generally owe a 10% federal penalty tax on the amount withdrawn. There are exceptions to this rule but generally, the penalty will apply. There is NO divorce exception to the 10% penalty on Traditional IRA’s – that only applies to QDRO funds from quailed plans which we will cover more in an article next week.
- Required minimum distributions (RMDs): You must start taking RMDs from your Traditional IRA by age 72, which means you’ll have to withdraw a certain amount each year and pay taxes on it.
With a Roth IRA, you contribute after-tax dollars, and your money grows tax-free. This means you won’t pay taxes on your contributions or earnings when you withdraw the money in retirement. Here are some key rules for Roth IRAs:
- Contribution limit: For 2023, you can contribute up to $6,500 if you’re under age 50, or up to $7,500 if you’re age 50 or older. However, your limits could be lower based on your income. If you make $139,500 as a single person in 2023 your contribution limit will be reduced and if you make over $153,000 as a single person in 2023 you cannot contribute to a ROTH IRA directly and must do a “backdoor” ROTH IRA to contribute to a ROTH IRA.
- Tax benefits: You won’t get an immediate tax deduction for your contributions, but you won’t pay taxes on your withdrawals in retirement
- Penalty for early withdrawals: You can withdraw your contributions from your Roth IRA at any time without penalty no matter your age. However, if you withdraw earnings before age 59 1/2, you’ll generally owe a 10% federal penalty tax on the amount withdrawn. There is no 10% exception for divorce for ROTH IRA earnings.
- Required minimum distributions (RMDs): Roth IRAs have no RMDs during your lifetime, which means you can leave the money in the account as long as you want. You can even pass these funds onto your heirs, and they will have the same benefits of tax deferred growth and tax-free withdrawals.
Which one should you take in the divorce?
We feel as if the Roth IRA is a “golden” asset. If you have a Roth IRA in your estate this means you already paid tax on these funds and now have a future of tax deferred growth and tax-free distributions ahead of you. It makes sense to take as much of the Roth IRA as you can. The ROTH IRA can also be a great negotiation tool to obtain more of the assets you may really want (such as the house) or a larger percent of the estate if you give the Roth IRA to a higher earning soon-to-be ex-spouse.
Also, if you are worried about taxes and need cash in the divorce, you can always redeem the corpus or what you invested into the ROTH IRA tax and penalty free. While we recommend you let your Roth IRA grow, if you are in a pinch and need to get through your divorce – this is an area to redeem funds without tax consequences.
What do I do now?
If you have questions on what to do next as you navigate the financial waters of divorce schedule a complimentary 30-minute phone consultation today and we can help you move in the right direction.