Traditional IRA vs Roth IRA

August 28th, 2009 | cashrunner | Posted in Finance

Most of us understand that IRAs are accounts that you use to save for retirement. But do you really know the difference between a Traditional IRA and a Roth IRA? Do you know when you should choose one over the other? Read on.

Traditional IRA

Quick Overview

A Traditional IRA is an account that you use to save for your retirement. You can open a Traditional IRA at your bank or at a brokerage. You may use it as a simple savings account or as an investment account for a portfolio of stocks or bonds. It’s entirely up to you. The contributions to a Traditional IRA are tax deductible. So you pay less in taxes each year. In addition, the money in the account grows tax free. That means if you earn interest, dividends, or capital gains, you won’t have to pay taxes on that income, at least not right away. It’s only when you withdraw the money at retirement that your earnings are taxed like ordinary income. The fact that your earnings go untaxed for so long means your investment will grow faster in the meantime. Plus, when you later withdraw your money, you will probably be in a lower tax bracket. As a result, you’ll pay less in taxes at that time.

Eligibility

Any worker under the age of 70 ½ can open a Traditional IRA account. There are no income restrictions to open an account.

Contributions

There’s a limit on how much you can contribute to a Traditional IRA each year. The annual contribution limit for tax year 2008 is $5000 ($6000 if you were age 50 or older by the end of 2008).

Single filers can earn up to $101,000 to qualify for a full contribution. Those earning between $101,000 and $116,000 are eligible for a partial contribution. Single filers earning more than $116,000 a year cannot contribute to a Roth IRA. (2008 Figures)

Joint filers can earn up to $159,000 to qualify for a full contribution. Those earning between $159,000 and $169,000 are eligible for a partial contribution.

You can also never contribute more than your taxable compensation for the year.

Tax Deduction

If you are not covered by an employer plan, IRA contributions are always fully deductible. However, if you are covered by an employer plan, you can deduct the full amount of your contribution only if your modified adjusted gross income is $50,000 or less (single) or $75,000 or less (married). You can only claim a partial deduction if your income is between $50,000 and $60,000 (single), $75,000 and $80,000 (married, both spouses covered), or $150,000 and $160,000 (married, only spouse covered). If you are covered by an employer plan and you earn more than $60,000 (single), $85,000 (married, both covered), or $160,000 (married, only one spouse covered), you cannot deduct your IRA contributions at all(2008 figures).

Withdrawals / Distributions

You must begin receiving minimum distributions by April 1 of the year following the year you reach age 70 ½. To calculate the minimum required distribution, divide the balance of your IRA account at the end of the previous year by the number of years in your life expectancy. All distributions of earnings are taxed as ordinary income.

In addition to being taxed at ordinary income rates, withdrawals before the age of 59 ½ also trigger a 10% penalty unless the following exceptions apply:

You withdraw the money you contributed before the due date of your next tax return.
You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
The distributions are not more than the cost of your medical insurance.
You are disabled.
You are the beneficiary of a deceased IRA owner.
You are receiving distributions in the form of an annuity.
The distributions are not more than your qualified higher education expenses.
You use the distributions to buy, build, or rebuild a first home. ($10,000 maximum)
The distribution is due to an IRS levy of the qualified plan.
The distribution is a qualified reservist distribution.

Conversions

You may convert from a Traditional IRA to a Roth IRA if your income is $100,000 or less. The entire amount will be taxed at ordinary income tax rates that year.

When to Choose a Traditional IRA

In general, Traditional IRAs are preferable to Roth IRAs when the following situations apply:

You are in a high tax bracket. This increases the value of a tax deduction. Multiply your average tax rate by the amount of your contribution to determine how much you will save in taxes for the year.
You expect to be in a significantly lower tax bracket when you retire. Earnings in a Traditional IRA are tax-deferred. That means you’re going to be taxed on them eventually. The greater the difference between your tax bracket now versus at retirement, the more you will save.
You are approaching retirement. The older you are, the more conservative you should be with your investments because if the market takes a downturn, your investments may not have enough time to recover. It’s time to shift from stocks to less risky investments. Naturally, the returns on these investments will be lower. This reduces the attractiveness of a Roth IRA (described in the next section) and makes the benefit of a tax deduction relatively more important.

Roth IRA

Quick Overview

A Roth IRA (named after the U.S. Senator who wrote the bill creating it) is another type of retirement account. Like a Traditional IRA, it can be used as a simple savings account or as an investment account. You can open one at a bank or a brokerage. Unlike with a Traditional IRA, contributions to a Roth IRA are not tax deductible. You won’t save on your taxes each year just because you’re making contributions to a Roth IRA. Like a Traditional IRA, the earnings in a Roth IRA account grow tax free. You don’t need to worry about paying taxes on interest, dividends, or capital gains each year. In fact, and here’s the primary advantage of Roth IRAs, you’ll never have to pay taxes on your earnings. This is a crucial difference between Traditional IRAs and Roth IRAs. With a Traditional IRA, you will have to pay ordinary income tax when you withdraw your earnings at retirement. With a Roth IRA, you won’t have to. You’ll get to keep everything.

Eligibility

There are no age restrictions to open a Roth IRA account. However, there are income restrictions.

Contributions

There’s a limit to how much you can contribute to a Roth IRA each year. The annual contribution limit for tax year 2008 is $5000 ($6000 if you were age 50 or older by the end of 2008) but the amount could be less than that depending on your income.

Single filers can earn up to $101,000 to qualify for a full contribution). Those earning between $101,000 and $116,000 are eligible for a partial contribution. Single filers earning more than $116,000 a year cannot contribute to a Roth IRA (2008 Figures).

Joint filers can earn up to $159,000 to qualify for a full contribution. Those earning between $159,000 and $169,000 are eligible for a partial contribution (2008 Figures).

In addition, you can never contribute more than your taxable compensation for the year.

Tax Deduction

Contributions to a Roth IRA account are not tax deductible.

Withdrawals / Distributions

All withdrawals after age 59 ½ are untaxed as long as your IRA has been open for at least five years.

You are not required to begin taking distributions because of your age. You can keep your funds in your Roth IRA account for as long as you like.

If you withdraw earnings from your Roth IRA before retirement age (legally set at 59 ½) or before the 5-year minimum period has passed, you will have to pay a penalty equal to 10% of the amount of the withdrawal unless you meet these exceptions:

You withdraw the money you contributed before the due date of your next tax return
You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
The distributions are not more than the cost of your medical insurance.
You are disabled.
You are the beneficiary of a deceased IRA owner.
You are receiving distributions in the form of an annuity.
The distributions are not more than your qualified higher education expenses.
You use the distributions to buy, build, or rebuild a first home. ($10,000 maximum)
The distribution is due to an IRS levy of the qualified plan.
The distribution is a qualified reservist distribution.

When to Choose a Roth IRA

In general, Roth IRAs are preferable to Traditional IRAs when the following situations apply:

You are in a low tax bracket. This reduces the value of a tax deduction you would get with a Traditional IRA.
You expect to be in a relatively high tax bracket even when you retire. This reduces the value of the tax deferral you would get with a Traditional IRA.
You are young. The younger you are, the more risk you can take with your investments. You could be invested mostly in stocks, which over a period of many years outperform less risky investment options such as bonds. Even if the stock market experiences a slump for a few years, it will eventually recover and average a higher return on investment. In a Roth IRA, your money will not only grow faster, you actually get to keep all that growth because earnings can be withdrawn tax free at retirement.

Photo Credit: g-hat

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