What is the Difference Between a Roth IRA and a Traditional IRA?
For many, not knowing where to begin when it comes to saving for retirement is determinant enough to never start. We hope by explaining the difference between a Roth IRA and a Traditional IRA we can help you decide which one fits best into your current and future financial situations. Of course, IRA’s are not the only means to save for a retirement, but for many, they are a great option in addition to a 401(k) or 403(b) or even a pension plan.
What is an IRA?
First, we should understand what exactly an IRA is. IRA stands for an Individual Retirement Account. One of the greatest advantages to an IRA, in our opinion, is the range of investments available to you. Unlike an employee sponsored 401(k), where your investment choices are limited to what is available in the plan, IRA’s allow you to invest as you wish i.e. Stocks, bonds, ETFs, etc.
Main Difference between a Roth vs. Traditional IRA
Put simply, a traditional IRA allows contributions to enter the IRA tax-free and until money is withdrawn at retirement, is it taxed (tax-deferred option). With a Roth IRA, contributions are taxed upon entering the IRA, thus, any earrings in the account grow tax-free.
Yearly Contribution Limits for both Traditional and Roth IRA
YEAR AGE 49 & BELOW AGE 50 & ABOVE
2002-2004 $3,000 $3,500
2005 $4,000 $4,500
2006-2007 $4,000 $5,000
2008 $5,000 $6,000
Characteristics of a Traditional IRA
As I said above, the main advantage (or disadvantage depending on your situation) with the traditional IRA is that the money goes into the account pre-taxed, meaning your taxable earnings for the year will be reduced by the amount you contribute to your traditional IRA (subject to the limits above). However, the money will be taxed when you retire and you start withdrawing from the account.
Traditional IRA’s mandate that withdrawals cannot begin until the account holder reaches the age of 59 ½ and requires that withdraws start at 70 ½. Regardless if you need the money or not, traditional IRA’s require you to start taking money out of the IRA at 70 ½.
Traditional IRA’s are popular because they are available to everyone; there are no income restrictions, like there is with the Roth.
Also important to know when deciding which IRA is best for you is that traditional IRA’s are not as flexible and are subject to penalties. Any contributions including principle contributions, made to a traditional IRA can be withdrawn at any time but will be subject to a 10% penalty.
Characteristics of a Roth IRA
Again, the main characteristic of a Roth IRA is that contributions are taxed upon entering the IRA and grow tax-free. Therefore, if your Roth IRA is worth $1 million dollars when you reach retirement, the entire million is yours, no taxes.
Unlike the Traditional IRA, a Roth does not have mandatory distribution ages. The advantage to this is, if you don’t need the money in your Roth when you are 70 ½, you can leave it growing tax-free.
Roth IRA’s do have limits as to who can invest in them. Roth’s are only available to single-filers making up to $95,000/annually or married couples making a combined maximum of $150,000/annually.
Lastly, a big advantage to Roth IRA’s is the flexibility they offer. Any money deposited into the IRA can be withdrawn for any reason tax-free. I know what you are thinking, and we do not encourage people to take money out of their retirement accounts, however, if there is an emergency, the Roth at least gives you some reassurance.
Which IRA is Best for Me?
In our opinion, the answer to this has a lot to do with your current age and income. In general, we believe if you are younger, you will benefit from a Roth IRA and if your income is close to the limits of the Roth, most likely a Traditional IRA is best for you. Let me explain.
Because a Roth IRA taxes you upon entering the account, you are taxed at the income rate you are currently at. Therefore, the younger you are, the more likely your tax rate will increase as you age, with your income. The benefit comes to paying a smaller tax rate upon entering the IRA versus paying a higher tax rate when the money is withdrawn at a higher tax bracket, which is what happens with a Traditional IRA.
If you are currently closer to retirement age and your income level high, you will most likely benefit from the Traditional IRA. Mainly because there is not a qualifying income limit, coupled with the tax-free contributions, you will likely face a smaller IRS bill come April. $
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Comments
I’m 18 and I recently opened a Roth. The current tax advantages of a traditional would be nice for sure, but completely tax-free money at the end should make it worth it. I don’t understand why more people don’t utilize these things. Even if they are terrified to death of investing, they might as well use it for CD’s or something.
@Blake: You are in a really good spot…I gleaned this out of About.com -
Consider the following four investors ages 25 – 55. Each invests $2,000 per year and earns 8%.
At age 65:
The investor who started at age 25 has over $585,000
The investor who started at age 35 has just $250,000
The investor who started at age 45 has just $98,800
The investor who started at age 55 has just $30,700
The results are quite dramatic and, as you might expect, the youngest investor comes out the best.
[...] As the tax deadline slowly creeps up on us, so to does the deadline to contribute to a 2007 IRA (Individual Retirement Account). IRA’s, which historically have served as a secondary retirement plan for most individuals, are a great way of paying less in federal income taxes while still saving for your future. For more information on the differences between a Roth vs. Traditional IRA click here. [...]
“Again, the main characteristic of a traditional IRA is that contributions are taxed upon entering the IRA and grow tax-free”
I think that might be a typo from what I read above. I might be confused.