Traditional IRA vs. Roth IRA: Which is Right for You? Review

Saving for retirement is an important financial task. With the future of Social Security in doubt and Medicare in even worse financial condition, it is important that every American set aside a portion of his/her income for the future.

Many Americans already have a 401K savings plan and are well on their way to financial security. But others do not have a 401K plan, either because their employer doesn't offer a plan; they do not work full time and are thus ineligible to participate in the plan; or they are self- employed and do not have a large enough business to implement a 401K plan. For these individuals, there are alternatives for retirement savings. Individual Retirement Accounts offer a means to save toward retirement by making periodic contributions throughout the year. The two main types of IRA are the Traditional IRA and the Roth IRA. Which one is right for you? Let's take a look at the similarities and differences:

Traditional IRA Commentary:

First, it is important to note the characteristics that distinguish one type of IRA from the other. The main difference between a Traditional IRA and a Roth IRA is the tax treatment of contributions and withdraws. It basically works like this: A Traditional IRA allows the contributor to deduct the money deposited to his/her IRA account from taxable income each year, up to a defined limit. When the money is withdrawn in the future, it will become taxable as ordinary income. In these respects, the Traditional IRA is very much like a 401K plan: Reduce taxes now, defer them for payment later when, hopefully, the individual tax bracket is lower.

When it comes time to withdraw money, Traditional IRA accounts have another requirement: Account holders must begin mandatory withdraws once they reach the age of 70.5. Failure to take the withdraws at that point will result in a huge penalty- currently a 50 percent excise tax on any amount not distributed! Obviously, avoidance of this penalty is reason alone to take the withdraws before this cut off date. Even if the money isn't needed for retirement living at the time, no one wants to pay a 50 percent penalty on their investment.

Roth IRA Commentary:

Established in 1998 and named after U.S. Senator William Roth, the Roth IRA is a unique retirement investment vehicle. Unlike a Traditional IRA, a contributor to a Roth IRA cannot deduct the money from taxable income, so there is no realized tax savings with a Roth IRA during the working years, before retirement. However, when the money is withdrawn in the future, it is completely free from taxation no matter how large the account has grown in size. From a purely tax perspective, the Roth IRA is best for individuals who anticipate remaining in a high tax bracket, even when they are in retirement. The money withdrawn from a Roth IRA will not be taxed, making it financially appealing to someone who expects his/her tax bracket to remain steady or rise during the retirement years. 

Withdraws on a Roth IRA are a little different. Because there is no tax to pay on future withdraws, the IRS is a little more lenient on taking withdraws. Not only is there no penalty if withdraws do not begin by a specified age, the holder of a Roth IRA never has to withdraw anything, if that is what he or she wishes.

Limitations/Rules/Exceptions Common to Both IRA's:

Both a Traditional IRA and a Roth IRA have certain limitations that investors need to keep in mind before investing. One is the contribution limit, which currently stands at $5,000 annually. This level has gradually increased over time and it continues to increase every year or every few years, depending on the latest tax laws that have been enacted. Those who are older (50 and up) can also contribute slightly more than the $5,000 limit.

In addition to the contribution limit, holders of both Traditional and Roth IRA can start withdrawing IRA money starting at the age of 59.5 years, without penalty. If funds are withdrawn sooner, both the Traditional IRA and Roth IRA account holder will be subject to a ten percent penalty. However, this penalty is waived for certain reasons. Disability, medical expenses, higher education expenses, first time home purchase, and a few other life events will result in no penalty if the IRA account holder uses the money for these purposes.  Taxes will also have to be paid on early withdraws, and this includes early withdraws from a Roth IRA. Remember- money withdrawn on a Roth IRA is normally not subject to tax, but it has to be a qualified withdraw of funds to avoid tax. A non- qualified withdraw (like taking out money before age 59.5 for reasons other than those mentioned above) will result in the distribution becoming taxable. There is one exception: The principal balance of funds placed in the Roth IRA is not subject to tax, no matter when it is withdrawn. Only the money above and beyond the contributions made (in other words, the capital gains portion) is subject to tax if the withdraw is unqualified.

One other limitation for both types of IRA is one's income level. If a single person makes more than $99,000 or if a married couple earns more than $156,000, then they cannot take full advantage of an IRA. At these income levels (these are 2007 limits, and are expected to increase each year), the $5,000 annual contribution limit slowly reduces as income climbs. Once income exceeds a set level ($114,000 for a single filer or $166,000 for a married filer, based on 2007 tax law), eligibility for Roth contributions comes to an end. Traditional IRA have similar limitations based on income, plus another important limitation: If you already have a 401K plan, then you may not be able to take the full $5,000 tax deduction with your Traditional IRA. The limit is gradually reduced until it reaches zero, based on your income and the amount of money you have placed in your 401K plan.

IRA Commentary:

Traditional and Roth IRA are both important investment options designed to help individuals who are worried about having enough money to live comfortably in retirement. Most anyone would agree that Social Security cannot be relied upon to produce a comfortable retirement and it is imperative that individuals take charge of their financial future by investing in 401K, Traditional IRA, Roth IRA, or a combination, if possible.

With Traditional IRA, an account holder has the advantage of being able to deduct the contributions from taxable income, saving substantial money in taxes- especially if the marginal tax rate for an individual is high. The tax savings is like making an instant return on the investment. For example, let's say you contribute the $5,000 maximum to your Traditional IRA and your income level places you in the 28 percent tax bracket. By writing this off your taxes, the tax savings would amount to $1,400, or 28 percent of the contributions. Of course, the Traditional IRA account holder will eventually have to pay tax on this money and any gains that are made on the investment when the money is withdrawn. But as long as the marginal tax rate for the tax payer is lower during retirement (and it usually is), then the net tax paid will be lower and the Traditional IRA account holder will win the tax battle.

Roth IRA do not allow contributions to be written off from taxable income, but the key advantage with a Roth IRA is that the withdraws in the future will be completely free from tax under most circumstances. Depending on the performance of an investment, a Roth IRA could prove to be an excellent way to save for retirement because, no matter how large the value of the Roth IRA or how much it increases in value over time, there will never be tax to pay. This is the great advantage of going Roth as opposed to Traditional and it encourages Roth IRA account holders to be more savvy in their investment choices. Knowing there will never be any tax to pay, the Roth IRA account holder has more to gain if his/her investments perform better than average.

Traditional and Roth IRA are not the only two types of IRA. There are actually several other types of IRA's, like the Simplified Employee Pension IRA, the Spousal IRA, and others. But Traditional and Roth are the best known and the ones that most people contribute. Depending on one's tax situation and predictions for future earnings and future marginal tax rate, the Traditional IRA may be better in some cases and the Roth IRA may be better in others. Investors should consider both sides carefully before making a decision and, if necessary, should consult an on- line source to obtain some quick advice. Some sites even have financial calculators that will advise curious investors on which IRA is right for them.  

Bottom Line Viewpoint:

Investing for the future is always a good idea, so look over your financial situation and determine what course of action is right for you. And don't forget: April 15, 2008, is not only tax day, it is also the deadline to make tax- deductible contributions to your Traditional IRA and deduct them for the 2007 tax year. So get started now, save yourself some tax money, and get your retirement plans in order during the 2008 year. Your future will benefit tremendously.