Traditional IRA vs. Roth IRA

There are actually 11 different types of IRAs, but the ones we hear the most about are the Traditional and Roth IRAs. Let’s look at them both to understand their differences.

Traditional IRAs (tax deferred)

The contributions for a Traditional IRA are of the “tax-deductible” kind. That means that, depending on certain factors which include your income tax filing status, adjusted gross income (AGI), and eligibility to participate in a tax-qualified retirement plan through employment, the money you deposit in your IRA isn’t taxed. And regardless, whatever earnings you have on your contributions over the years the IRA is opened won’t be taxed until you withdraw that money many years later.

For example, let’s say you made $36,000 during the year, and you put $2,000 of it into an IRA. You would pay income tax on only $34,000. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement (after age 59 ½) then, and only then, will the money be taxed as income at your ordinary income tax rate. Also keep in mind all money must be withdrawn from the account no later than the April 1 following the year the owner turns 70 1/2.

If you withdraw the funds before age 59 1/2, then in most cases you’ll have to pay both income tax and a 10% penalty on whatever earnings have accrued — but if the funds are used to pay for “qualified higher education expenses” or for one of the other 8 exceptions (including death or disability) then the 10% early withdrawal fee will be waived.

Remember that you can put just about anything you want in an IRA account. While CDs are a safe bet, they tend to have lower long-term returns than riskier investments – which means you’re taking a risk that inflation could erode your returns. Just ask your great Aunt Gertie how much things used to cost when she was young to get an idea of inflation’s effects.

If you are willing and able to accept the additional risks (i.e. you could lose money), you can invest your IRA money in mutual funds or stocks. Especially for those who have more time until they pull their money out of an IRA, mutual funds can be a good choice.

Roth IRA (tax free)

The tax breaks for a Roth IRA are different than a Traditional IRA. Unlike a contribution to a Traditional IRA, a Roth IRA contribution is never deductible. Taking the above example on your yearly earnings, you’d still be taxed on $36,000 even though you had put the same $2,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it — and that includes the earnings — will be taxed, assuming that the Roth IRA has been open for at least five tax-years and you are older than age 59 1/2. That’s right – no tax on the entire account! All you have to do is to wait until you can withdraw it penalty-free.

In other words, the Roth offers tax-exempt rather than simply tax-deferred savings. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions if those were deducted when made). The Roth doesn’t. As long as you follow the rules, you never pay taxes on your gains. So paying the taxes now before contributing to the Roth may work out to be better for you than paying taxes later on your investment profits.

The Roth makes great sense for people otherwise limited to making non-deductible contributions to a traditional IRA. And the Roth is fully available to single filers making up to $95,000 and couples making up to $150,000. It also allows you great flexibility by allowing you, in many cases, to withdraw your principal contributions at any time tax-free, without penalty. First-time homebuyers can also pull out $10,000 in profits penalty free and tax-free if the money has been in the Roth IRA for at least five tax years. Barring these exceptions, though, early distribution or profits withdrawn before retirement age and before the money has been in the Roth for at least five tax-years will be taxed, plus you’ll also incur a 10% penalty when those earnings are taken before age 59 1/2.

So Which to Choose?

The answer depends on your current tax bracket, your anticipated tax bracket in retirement and when you expect to begin withdrawing funds. Briefly, you will have an advantage from contributing to a tax-deductible Traditional IRA only if you can deduct the contributions from your taxes and anticipate being in a lower tax bracket in retirement. If you expect to be in the same or a higher tax bracket in retirement, then a Roth IRA may be preferable because you’ll be able to make completely tax-free withdrawals, provided you meet the 5-year holding period and have reached age 59½.

Additionally, in a Roth IRA, you’re not required to begin minimum withdrawals at age 70½. This makes the Roth IRA ideal for estate planning, since you can potentially leave more funds to your beneficiaries.