Traditional vs. Roth IRAs

Investors should take advantage of the government endorsed tax advantages of IRA accounts by maximizing their contributions each year. This guide gives you some information to decide whether a Roth IRA or Traditional IRA is best for you.

An IRA is an Individual Retirement Account. All IRAs of any type are held in custody at a bank or a brokerage, rather then by the owner, and they may be invested in anything the custodian has access to. These investments options change from custodian to custodian. Because of the fact that IRA’s require extra work for the custodian bank or brokerage, they often involve an annual maintenance fee. Some custodians will waive the maintenance fee when your account reaches a certain level, such as $5,000.

IRAs come in two main flavors: Roth and Traditional. Choosing the right type of IRA is a matter of deciding whether you’ll pay taxes on your money: up front (Roth) or upon withdrawl (Traditional). To help you decide, make sure to read our step by step guide on prioritizing your retirement investments.

For a traditional IRA, the only criteria to be able to contribute is sufficient income to make the contribution. For it to be most effective, however, the contributor should pay attention to other eligibility requirements for tax deductibility of the contributions. These requirements are based on income, filing status, and the availability of other retirement plans. All transactions in the account, including contributions, are not subject to tax while funds remain in the account. Only when cash is withdrawn from the account for any reason does federal income tax apply.

The Roth IRA, on the other hand, works opposite. Contributions are subject to taxation; however, qualified withdrawals are made without tax penalty. It also has fewer restrictions on withdrawal than the traditional IRA.

In both cases, all transactions that take place within the account, like capital gains, dividends, and interest, are made with no tax liability.

In addition, income limits, both upper and lower, are different for the Roth and traditional IRA, with the traditional IRA having a lower overall income range.

Advantages of a Traditional IRA

In traditional IRAs, contributions are often tax-deductible; for Roth IRAs, contributions are not tax deductible. And because the taxes on the traditional IRA are charged after you take cash out of the IRA, if you expect your income to be less after retirement (putting you in a lower tax bracket), then you should take a traditional IRA for the tax advantage you will have.

You may be able to withdraw cash from a traditional IRA early if necessary for purposes such as qualified educational or medical expense, or for buying a first home. You should, however, be aware that the penalties may be substantial.

The traditional IRA is designed to provide retirement benefits for lower-income workers, so there are income eligibility requirements to take full advantage of the tax benefits.

Benefits of a Roth IRA

A Roth IRA is better than a traditional IRA for those with a lot of disposable income who anticipate a healthy, larger income after retirement. The Roth IRA also has very liberal disbursement requirements, and does not have a forced distribution age like the traditional IRA.

A traditional IRA must be disbursed at a specific time, and an annual minimum distribution will apply after the owner starts making withdrawals after age 59.5. There are no such requirements on a Roth IRA, though early withdrawals of earnings – not contributions – can incur heavy penalties. There are exceptions similar to the ones on the traditional IRA, though, such as buying a first home and paying qualified educational expenses.

Contributions to your Roth IRA can be withdrawn at any time, with no federal tax penalty. And if you convert a traditional IRA into a Roth IRA, after a “seasoning” period that is currently 5 years, you can withdraw up to the total of the converted amount just like a regular Roth IRA contribution – resulting in potentially significant tax savings.

Because Roth IRA contributions are made from after-tax income, and it is not taxed on disbursement, it’s easier to determine what your IRA is actually worth. Withdrawals up to the total of contributions are federal income tax free (check state regulations, though), and withdrawals of earnings are often also federal income tax free.

You can have both a Roth and a traditional IRA at the same time.