Given the number of times we’ve written about the subject, hopefully you’re familiar with the basic difference between a Roth IRA and a traditional IRA. If this has escaped you, however, here’s a brief refresher: Contributions to a traditional IRA are deductible, and contributions to a Roth IRA are not. Plus, when you retire and receive distributions from a traditional IRA, they are taxed. When you receive them from a Roth IRA they are not. So you have a choice: Be taxed on your retirement savings now, or later.
That's the most known difference between the two, but we'll help you fill in the details, so that you can make a truly informed decision about which retirement account is best for you.
Tried and true, the traditional IRA works like a savings account. Each year, you make a contribution. Your contributions are invested inside the account, and if your account earns money, it's not taxed. The lack of tax on your investment earnings allows your money to grow bigger faster. And that’s not all. You could contribute up to $5,000 in 2008, and contributions to your account are deductible. In order to fully deduct contributions to a traditional IRA in 2008, your adjusted gross income must have been $53,000 or less as a single person or $85,000 or less as a married person filing jointly. Furthermore, if you're over the age of 70 ½, forget about contributing to your traditional account: It’s not allowed.
Fortunately, there is no age limit on a Roth IRA, and the income limits for Roths are much higher. So if you earn too much income to contribute to a traditional account, don’t give up yet. Although no deduction is permitted for contributions to a Roth IRA, your investment will still grow tax free inside the account. Even better, your contributions and earnings won’t be taxed when they are distributed to you. Of course, Congress likes to complicate stuff, so income limitations apply. You can contribute to a Roth as long as you have an adjusted gross income of less than $116,000 as a single person or $169,000 as a married person filing jointly. These numbers are more forgiving than the traditional IRA limits, so a broader assortment of folks qualify for the Roth account than the traditional one.
Finally, did you know that you can have and contribute to both types of accounts? There is no law against opening both a Roth IRA and a traditional IRA. Of course, the overall contribution limit still applies. You can contribute up to $5,000, but you have to spread it between the two accounts.
For instance, if you can take a full deduction for your traditional IRA contribution, you might choose to put all $5,000 into that account. But if your deduction is reduced because your income is too high, you might contribute the deductible amount to your traditional IRA and the rest to your Roth. Furthermore, the IRS will allow you to move payments made to one account into another if you make the move in the same year as the original payment. This means you don’t have to plan your traditional/Roth split in advance. Having both kinds of accounts provides you with more flexibility at tax time. Don’t forget, though, that maintaining two accounts means paying two sets of investment fees, which might outweigh the benefit if your service providers are expensive.
Now that we’ve considered how to put money into your IRA, let’s think about how to get it out. There are two ways: withdrawals and distributions. You make a withdrawal when you remove money from your account prior to your retirement. In contrast, you receive a distribution when your account trustee makes a payment to you after your retirement. These two things are taxed quite differently if you have a traditional IRA, and they generally aren’t taxed at all if you have a Roth.
Withdrawals from a traditional IRA can be painful under the wrong circumstances. In addition to paying tax on the money you receive, you may also have to pay a 10% penalty. The penalty applies to most withdrawals that you take before you reach the age of 59 ½. There are several exceptions though. You may avoid the penalty if you use the money for large, unreimbursed medical expenses, payments for medical insurance, higher education expenses, or to buy or build your first home. If any one of those exceptions apply to your withdrawal, you will still be taxed on the money that you receive, but you can avoid the 10% penalty.
Roth IRAs are much different. After you’ve had your account for five years, you can withdraw money from it tax free and penalty free. Of course, if you remove your money within five years of opening your account, you will be subject to the usual 10% penalty unless one of the above exceptions applies. Even if you pay the penalty, though, you still will not be taxed on your withdrawal. This no-tax rule makes Roth IRAs a good choice for people who want to save for retirement but who are afraid that they might need to use their savings for big, unanticipated expenses in the future.
The primary purpose of an IRA is to save money for your retirement. So how do the traditional and Roth IRAs compare when you reach that promised land? The usual rule of thumb is that distributions from a traditional IRA are taxable, while distributions from a Roth IRA are not. Furthermore, participants in traditional IRAs are required to receive distributions from their accounts, whether they want to or not. Participants in Roth IRAs are not required to take any distribution at all.
So how should you choose between these two options? If you expect to be in a lower tax bracket in retirement, the traditional IRA might be the best path. However, if you are paying lower taxes now but are expecting an inheritance or career promotions to increase your income later, a Roth might be for you. Or, to be more cynical, if you expect Congress to raise taxes in order to cover the astounding federal debt, Roth is your winner. Finally, if you expect to die rich, the Roth is a better choice for your heirs. You aren’t required to take minimum distributions from your Roth account, which will preserve your account balance. And when your heirs receive distributions from your account, they will be tax free, just as if they had been paid to you.
Of course, you can always hedge your bets by funding both a traditional and a Roth IRA. Your choices about how much money to put where may vary from year to year. Contribution limits, your tax bracket, your concerns about large future expenses and your predicted retirement tax rate should all play a role in your yearly decision. Use the information that you’ve learned here, and your careful planning will keep the IRS from taking more than its fair share of your nest egg.
Be sure to check out the complete archive of Daily Deductions.
Daily Deduction: IRA Contributions
How To Choose a Less Taxing 401(k)
How to Roll Over Your 401(k) Into an IRA