Choosing a Roth IRA Vs. A Traditional IRA

Roth IRAs and traditional IRAs are individual retirement accounts held by commercial banks and retail brokers that allow individuals to invest in different asset classes. Most people are eligible to contribute to both retirement plans. But, how do you choose a Roth IRA vs. a Traditional IRA?

Roth IRAs

The main advantage of a Roth IRA is that it allows having tax free investment earnings upon withdrawal provided you meet certain requirements. Although there are no tax deductions for contributions, upon retirement, the amount withdrawn is not taxed. I started a Roth IRA at 28 and I contribute $4,000 yearly with an average annual return of 7%. At 65, my account balance will be $686,244 and I won't have to pay a penny to the government. By investing regularly to your Roth IRA you have the potential to grow your account and ensure high tax-free returns over long periods of time. And it makes more sense when you are younger because you take advantage of the time value of money and you are in a lower tax bracket.

Besides, with a Roth IRA there is no penalty for early withdrawal of your principal contributions. In case of financial emergency, you can withdraw your original contributions at any time without paying taxes or penalties. In that sense, a Roth IRA can be used both as a retirement account and an emergency fund.

Summarizing, the pros of a Roth IRA are:

- Tax free earnings

- No penalty for early withdrawal of principal

- No minimum withdrawal requirements

- No mandatory distribution age

- Variety of investment options, including stocks, bonds, mutual funds, commodities or even real estate.

On the other hand, Roth IRAs have also drawbacks:

- You may not qualify because of your income level

- You have to liquidate the assets before withdrawing the money (illiquid)

- If you have a financial emergency when the market is down, you are forced to liquidate at a loss (high market risk).

- It may take a week for your funds to be credited to your account when requesting a Roth IRA distribution.

Traditional IRAs

With a Traditional IRA you can have tax deductible contributions to your retirement plan depending on your income level, tax filing status and other requirements. Unlike the Roth IRA, the earnings are taxed. However, the tax savings during the contribution years may be enough to lower your tax bracket during your working years allowing your money to mature tax free until you withdraw it in retirement.

Summarizing, the pros of a Traditional IRA are:

- No income level restrictions

- Tax deductible contributions

- Taxed earnings upon withdrawal, allowing lower tax rate in retirement

- Variety of investment options, including stocks, bonds, mutual funds etc.

The main disadvantage of Traditional IRA is the minimum required distribution. This requirement practically forces Traditional IRA holders to withdraw a certain amount of their funds even if they don't want to. Moreover, it is not feasible to determine the tax rate in retirement.

Is Roth IRA better than Traditional IRA?

As a financial adviser, I would not give an affirmative response to which is better, Roth or traditional IRA. It depends on your individual circumstances. Both retirement accounts have distinctive advantages and can be great tools if you want to diversify your taxes in retirement.

What I do is contributing to a 401k plan and also having an individual Roth IRA. In that way, I take the full benefit of decreasing my taxable income with my 401k contributions and take advantage of tax free withdrawal in retirement from my Roth IRA. What I aim for is tax diversification in my retirement planning strategy.

Sources:

http://www.investopedia.com/terms/t/traditionalira.asp

http://www.investopedia.com/terms/r/rothira.asp

http://beginnersinvest.about.com/cs/iras/f/tradvsrothira.htm

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