Differences Between Roth And Traditional IRAs
Individual retirement accounts (IRAs) provide a relatively safe way to grow your money for retirement and they offer significant tax advantages.
There are two types of personal retirement accounts you can open: Roth and traditional IRAs. Understanding each account and their differences helps you determine which IRA is best for your financial situation and retirement plans.
Traditional IRA Basics
A traditional IRA is a personal retirement savings account held at a bank or a brokerage firm that can be funded with investments such as stocks, bonds and mutual funds offered through the financial institution where your account is held. Traditional IRAs provide tax savings, including tax-free growth of earned interest, dividends and capital gains while the money is in the account. You also usually claim a tax deduction each year that you make a contribution to a traditional IRA. While your contributions to a traditional IRA are not taxed, you pay have to pay taxes when you remove the funds from the account at retirement.
Roth IRA Basics
A Roth IRA is a personal retirement savings account also held at a bank or brokerage firm that can be funded with a wide variety of investments, including stocks, bonds and mutual funds. Roth IRAs also offer tax savings, including tax-free growth of earned interest, dividends and capital gains while the money is in the account. Contributions made to a Roth IRA are taxed before they reach the account, but you are not taxed when you withdraw the money. Withdrawals of contributions are tax free after the Roth IRA has been open five years, and you can withdraw investment earnings tax free after you reach the age of 59 ½.
Traditional Vs. Roth IRAs
When it comes to investments, traditional and Roth IRAs work the same way. You fund the IRA and then move the money into various investments. With both types of accounts, the interest, dividends and capital gains grow tax free. If you are employed and earning an income, you can currently contribute to both types of accounts up to $5,000 per year until the age of 49 and $6,000 per year if you are 50 or older. Contributions to either type of IRA must come from taxable income earned from working. However, there are several important differences between traditional and Roth IRAs.
Consider the following differences when making a decision regarding which type of IRA is right for your financial situation.
Traditional: Contributions are taxed at the prevailing tax rate when money is taken from the account at retirement. Your contributions are not taxed when you initially deposit them into your account.
Roth: Because your contributions are taxed before they land in your account, you money is not taxed when it is removed from the account.
Traditional: No contributions are allowed once you reach age 70 ½.
Roth: No age limits exist on contributions.
Traditional: Anyone with a taxable income can contribute to a traditional IRA, no matter how much they earn.
Roth: There are income limits for contributing. In 2011, single individuals with a modified adjusted gross income of $125,000 and higher could not contribute to a Roth IRA.
Traditional: Contributions may be tax deductible. Eligibility is dependent on a variety of factors including whether you are currently participating in an employer-sponsored retirement plan such as a 401(k), SEP IRA or SIMPLE IRA. Enrollment in one of these pans can limit or preclude tax deductibility.
Income also dictates if and how much a person can deduct. In 2011, for instance, an individual filing single or as head of household with no active participation in an employer-sponsored retirement plan who earned $56,000 or less in modified adjusted gross income could fully deduct all contributions to a traditional IRA. Individuals earning from $56,000 to $66,000 got a partial deduction, and those earning more than $66,000 had no deduction.
Roth: No contributions are tax deductible.
Required Minimum Distribution (RMD)
Traditional: Account owners must begin receiving minimum distributions of money in the account on April 1 of the year following their turning 70 ½-years-old.
Roth: No RMD.
Traditional: If you pull money out of the account before the age of 59 ½, you will be subject to an early distribution penalty. Exceptions to the early disbursement penalty rule include withdrawing money in order to pay for college expenses, medical costs greater than 7.5% of your adjusted gross income and expenses due to sudden disability. You can also withdraw up to $10,000 penalty free for a first-time home purchase. Finally, there are no penalties if you transfer the money into another type of retirement account.
Roth: After the account has been open five years, you can withdraw any money you deposited into the account without incurring a penalty. You will, however, usually pay a penalty if you withdraw investment earnings before the age of 59 ½.
Deciding Which Account Is Best for You
If you do not meet the income requirements for a Roth IRA, a traditional IRA is your only choice. Otherwise, you need to take a few factors into consideration when making your decision.
If you want to take advantage of the tax deductibility of your IRA contributions, you might consider choosing a traditional IRA. Opting for a traditional IRA also makes sense if you expect to be in a lower tax bracket when you retire, because you will pay less taxes at that time than you would now.
However, the flexible benefits of a Roth IRA may make it a more appealing choice. You might benefit from your ability to withdraw contributions without penalties. You might also prefer to have no minimum distribution requirements. Finally, if you expect to be in a higher tax bracket when you retire, choosing a Roth will allow you to get your contributions taxed at a lower rate now, and you won't have to worry about taxes later.
Splitting Your Contributions
If you are eligible for a Roth and traditional IRA, you may find it advantageous to split your maximum contribution between the two by depositing the tax deductible amount of your income into your traditional IRA and the remainder into a Roth. When considering doing this, factor in potential additional costs such as fees associated with funding both accounts. Your total contributions to both IRAs can’t be more than your limit for the year.
Now that you’re armed with the facts when it comes to Roth and traditional IRAs, you can use them to your advantage when planning for your retirement years.