Retirement Planning: Traditional vs. Roth IRAs

Retirement planning is one of the largest and most important financial commitments that you can make in life, as you may need to accumulate millions of dollars worth of savings to ensure a comfortable retirement. To help you meet that end, U.S. Congress has created Traditional and Roth IRA vehicles, which provide tax relief for long-term investors. It is critical that you become familiar with how both plans are structured--so that you may choose the right account for your retirement portfolio.

Traditional Vs. Roth IRA Contributions

Traditional IRAs allow for tax deductible contributions, while Roth IRAs are funded with after-tax money. In 2010, a single filer may generally contribute $5,000 into Traditional and Roth IRAs, combined. As a married couple, you may both put $5,000 into individual retirement accounts--for a total of $10,000 between the two of you. The IRS does allow you to contribute an extra $1,000 into IRAs--for a $6,000 limit when you are at least 50 years old.

Be advised that IRA contribution and deduction limits are scaled down for high earners. Your Traditional IRA deductions are lowered from $5,000, if you have a retirement plan at work and are a single filer with a modified adjusted gross income of at least $56,000. Alternatively, you cannot put any money into a Roth IRA--with a modified adjusted gross income of $120,000, or more.

Traditional Vs. Roth IRA Tax Deferral

Both Traditional and Roth IRAs provide for tax deferral. This means that you will not be responsible for paying taxes on interest, dividends, and capital gains as they occur within your retirement account.

Traditional Vs. Roth IRA Withdrawals

At retirement, your Traditional IRA withdrawals will be taxed at ordinary income rates of 10, 15, 25, 28, 33, and 35 percent. The Roth IRA, however, allows for tax-free withdrawals because your contributions into the Roth were already taxed. To best take advantage of these tax breaks, you should not tap your retirement accounts for cash until age 59 ½. With the Traditional IRA, you may be subject to a 10 percent additional tax penalty on early withdrawals. With the Roth IRA, you can take out your principal at any time, but you will be penalized for making withdrawals on investment gains.

Special exemptions do exist for early withdrawals. You may be able to bypass the 10 percent tax penalty--if you use IRA cash to provide for tuition expenses or a first-time home purchase.

IRA Required Minimum Distributions

The IRS enforces required minimum distributions for Traditional IRAs. After age 70 ½, you must start taking withdrawals from the Traditional IRA. To calculate your required minimum distributions, you will complete IRS worksheets that take the size of your IRA balance and life expectancy into consideration. You will be subject to significant tax penalties--if you fail to take your Traditional IRA required minimum distributions.

Required minimum distributions, however, are not applicable to Roth IRAs. Roth IRAs are therefore ideal as part of an estate plan--where you may decide to leave unspent retirement money to your heirs.

Retirement Planning Strategy

Because of its tax-free withdrawals, a Roth IRA would be more so ideal if you are a young professional, who expects to retire within a higher tax bracket. Because of the effective bypass to capital gains taxes--you should also put your most aggressive investments into the Roth for additional savings. If you are already a high earner, you may prefer the Traditional IRA, in order to deduct the contributions from your current taxable income.

Retirement Planning - Traditional Vs. Roth IRA, Sources:

IRS: 2010 IRA Contribution and Deduction Limits

IRS: Retirement Plans FAQs regarding IRAs

IRS: Roth IRAs