The Differences Between a Traditional and Roth IRA

You may already know that IRA stands for Individual Retirement Arrangement (it was formerly called an Individual Retirement Account). It’s a special tax-advantaged investment vehicle that’s available to the vast majority of Americans. But do you know whether a traditional or a Roth IRA is best for you? I’ll explain the basic differences between the two types so you’ll know which one is more beneficial for your situation.

What Is a Traditional IRA?

With a traditional IRA you generally don’t pay taxes on the money that you put in the account. For example, if you earn $100, you can invest $100. You pay taxes on your income and earnings in the future, after you retire and begin to take qualified distributions from the account. You defer paying taxes on income and earnings until you withdraw money from a traditional IRA. So instead of getting taxed on the amount of money you put in the account, you get taxed on the amounts that you take out. That gives you an immediate tax break in the current year.

What Is a Roth IRA?

A Roth IRA, on the other hand, has the opposite taxation requirement. You have to pay tax upfront on the money that you invest in the account. When you take a qualified distribution from a Roth during retirement, you don’t owe a dime in taxes because you already paid taxes on the front end. All the earnings that have accumulated in the account for years or decades get a free ride from taxes, too. So, investments in a Roth IRA grow completely tax-free!

What are the Pros and Cons of a Roth IRA?

Without a doubt, tax-free growth is the best part about having a Roth IRA. But there are a few more advantages to a Roth:

• You can fund it at any age. That’s different from a traditional IRA because you can’t make contributions to a traditional account after the age of 70½.
• You never have to take a distribution. Whereas traditional IRA owners must begin taking distributions starting at age 70½.
• You can easily pass money to your heirs. Since you’re allowed to contribute money at any age and never have to take a withdrawal, it’s a great vehicle for giving money to your beneficiaries.

However, having to pay taxes up front for Roth IRA contributions can be a disadvantage when compared to a traditional account, if it means that you don’t invest as much. Let me explain: Let’s say you earn $100 and want to contribute it to a Roth IRA. If your average tax rate is 25%, you’d have to pay $25 in taxes before making the contribution. That would only leave you with $75 to put in the Roth account. Investing with after-tax money could end up being less total money over the long run when compared to investing pre-tax money in a traditional IRA. However, that could be completely overshadowed by the tax-free advantage if your account has enough growth.

Another disadvantage to a Roth IRA is that you can’t exceed an annual income limit that’s set by the Internal Revenue Service (IRS). Here are the 2010 income limits:

• For single taxpayers, Roth contributions are phased out or reduced if you have modified adjusted gross income (MAGI) between $105,000 and $120,000. When your MAGI is $120,000 or more you can’t make a Roth contribution.
• For married taxpayers who file a joint return or for qualifying widow(er)s, Roth contributions are phased out if you have MAGI between $167,000 and $177,000. When your MAGI is $177,000 or more you can’t make a Roth contribution.

What is a Roth IRA Conversion?

If you make too much money to fund a Roth IRA, another way to open one is to convert funds in a traditional IRA to a Roth. And by the way, you can convert the entire amount in your account or just a small portion of it. When you do a Roth conversion you must pay taxes on any funds that weren’t already taxed. But get this: The IRS has put a special incentive in place to help you manage the tax liability for doing a conversion this year. If you make a Roth conversion by the end of 2010, you’re allowed to split the tax liability equally between the next two tax years—2011 and 2012.

However, be aware that even if you convert funds to a Roth IRA, the income limits for making contributions still apply. So if you make too much money (remember, that’s over $120,000 for single filers and over $177,000 for joint filers in 2010) you won’t be eligible to contribute new funds to your Roth nest egg. But that’s okay because the investment will grow tax-free for as many years as you keep it in the account.

Should You Have a Traditional or a Roth IRA?

Here are four questions to help you decide whether you should have a traditional or a Roth IRA:

1. Do you think U.S. income tax rates will be higher in the future, when you’ll need your IRA money? If so, paying a lower tax rate now for Roth contributions or for a  Roth conversion is better than paying a higher tax rate on traditional IRA withdrawals later on.

2. Do you think your income tax bracket will be higher when you retire than it is now? That’s usually the case for young workers who are just starting out. Again, paying less tax sooner for Roth contributions or for a conversion, rather than paying more tax later on when you withdraw from a traditional IRA, is better.

3. Can you pay the tax liability for converted funds from sources other than your IRA? If you convert a traditional IRA to a Roth in 2010, you don’t have to pay the taxes until the 2011 and 2012 tax years.

4. Did your traditional IRA take a beating in the last few years? If it hasn’t fully recovered, having a lower account value means you’ll pay less tax to convert it to a Roth than if the account value was higher. That’s a way to make lemonade out of financial lemons!

The traditional versus Roth IRA question is not a simple one. At dinkytown.com you’ll find helpful resources such as the Roth vs. Traditional IRA Calculator to help you understand which type of account is right for you. The Roth IRA Conversion Calculator will show you what advantage, if any, you’d get from doing a Roth conversion. Of course, everyone’s tax situation is different, so it’s a good idea to speak with an accountant or a financial adviser about whether doing a Roth conversion is best for you.

(Photo by thinkpanama)

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