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Difference between a Roth and a Traditional IRA

Roth and Traditional IRA’s are like two cars in opposite lanes – they are similar vehicles with the same purpose, but traveling in different directions. These differing approaches have to do with income taxes and when they are paid, but other distinctions apply also: income and eligibility limitations, limitations on how much can be contribute to the account each year, and penalties for early withdrawal.

IRA’s, or Individual Retirement Accounts, are “vehicles” for contributing money and saving for your retirement. Those contributions are used to purchase mutual funds, stocks, bonds and other investments, which grow inside the IRA tax free.

Here are some of the important differences between a Traditional IRA and a Roth IRA.

1) A Traditional IRA is said to be a “tax-deferred” retirement savings account. It does not require you to pay income taxes until you withdraw the money when you retire. A Roth IRA is just the opposite. You invest after-tax-dollars, and pay no income taxes when you withdraw funds upon retirement.

2) Almost anyone with earned income can contribute to a Traditional IRA although, due to income restrictions, the contribution may not be fully deductible. However, there are income limitations for contributing to a Roth IRA. If your income is above the limits, you won’t be able to contribute to a Roth IRA.

3) With a Traditional IRA, you are required to start withdrawing from the account by the time you reach 70 ½, although you can start withdrawing at age 59 ½. With a Roth IRA, you can leave your money in the IRA for as long as you want, no matter how old you are.

Advantages of a Traditional IRA

All your dividends, interest income, and capital gains are allowed to grow without being taxed, an opportunity for the IRA to grow much faster than if it were taxed. You may also be eligible for a tax deduction for your contribution, if you have no other retirement plan, such as a 401(k), at work. If you believe your income will decrease by the time you retire and you will be in a lower income bracket, a Traditional IRA is probably better for you. The deduction for your contribution will be removed from your current tax bracket now and, once you retire, you will pay taxes on the income when it is in a lower tax bracket.

With the Traditional IRA, there is a stiff penalty of 20 percent if you make an early withdrawal, plus you have to pay taxes on the money. There are some other distributable events, however, for which penalties will not be assessed, including death, disability, and severance from employment. There are also hardship withdrawals available as long as you meet “needs” and “satisfaction” tests.

You are permitted, up to certain limits, to borrow money from your traditional IRA, usually limited to 50% of your vested account balance. If you default on the loan, the entire outstanding balance on the loan is taxable.

Advantages of a Roth IRA

Just as with a Traditional IRA, your dividends, interest income, and capital gains are allowed to grow without being taxed. Since there is no deduction available for your contributions, you pay into the Roth IRA with after-tax-dollars. Thus, when you take out the money when you retire, you needn’t pay taxes on it. The Roth IRA offers more flexibility when it comes to taking the money out, however. You can withdraw your contributions early, but not any earnings, without any type of penalty. Thus, you have access to your money at all times. You cannot borrow from the Roth IRA, but you can take the money out.

Another attractive feature for some is that there are no mandatory withdrawal requirements for the Roth IRA. You can let your money grow as long as you want, with no requirements to take it out.

Conversions

A conversion from a Traditional IRA into a Roth IRA is a taxable event, though. For conversion of the entire account, the proceeds (less non-deductible contributions) are taxable as ordinary income, which may put you into a higher income bracket. You aren’t required to convert your entire IRA. Distributions must be deposited into the Roth IRA within 60 days, and any withdrawal of converted amounts within 5 years is subject to penalty. Reasons one may want to convert include the assurance that future gains are distributed to your beneficiaries tax free, to reduce the size of your estate, and to avoid having to take distributions at age 70 ½.

Photo courtesy of Michael R. Swigart