Differences Between Roth and Traditonal IRAs

Now that I'm retired, I'm finally seeing the benefits of years of careful saving and investments. My wife and I have several IRA accounts and they proved to be a great way to save money, and save money on taxes, both while we were working and contributing to them, and now that we are taking distributions of the funds.

An IRA (Individual Retirement Arrangement) is a tax free or tax deferred way to save for retirement. There are two main types, a traditional IRA and a Roth IRA. An IRA is a type of account, the investment can be in stocks, mutual funds or a safe money market account, you simply designate the account as an IRA. While you are working and earning money, you contribute it to the account. This reduces your taxable income and may even be deductible. When you retire, you are able to withdraw the funds on a regular basis, called distributions.

Here are the key differences between a traditional IRA and a Roth IRA:

Traditional IRA
The amount you contribute to a traditional IRA may be fully or at least partially deductible and the the amounts in your IRA account, including earnings and gains, are not taxed until distributed.

Distribution can happen (without penalty) anytime after age 59 1/2. The whole idea is you are able to save the money tax-free, while you are younger and at a higher tax bracket, and then withdraw and spend it when you are older and retired and probably at a much lower tax bracket.

The penalty for early withdrawl, under age 59 1/2 is harsh. There is a 10% additional tax, plus your normal tax rate. So if your normal rate is 28%, you will give the IRS almost 40% of the money if you withdraw it early.

Roth IRA
The Roth IRA is an IRA and has the same rules, except. the deductions to a Roth are non deductible. The distributions however, are tax free. Unlike a traditional IRA, you may continue to make contributions to a Roth IRA after age 70 1/2. You can also leave amounts in a Roth as long as you are alive, there is no requirement to begin distribution, as there is with a traditional IRA. A key rule is the account or the annuity must be designated as a Roth IRA when it is set up, you can't switch it later.

There is also another type of account called a Designated Roth Account. This allows a 401K employee retirement savings account to be considered a Roth Account and subject to those unique tax rules.

Limits
For 2010 and 2011, the most an individual can contribute to a traditional or Roth IRA usually is the smaller of $5000 ($6000 if you are age 50 or older) or the total taxable compensation for the year. If you only earned $2500, you can't put $5000 into an IRA. Careful, the IRS even has a special 6% tax on any excess contributions you may make to your account. This contribution limit is also affected by other retirement benefits you receive from your employer.

The IRS is the best source for IRA information and has a great web page with good basic summaries of the two types of accounts with links to the full rules and regulations of each. Learn the rules and consult with a tax professional about your personal situation before making any moves.

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