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Roth IRA vs. Traditional IRA - Which one is Better

Retirement is important. Planning for retirement can be crucial to living comfortably in retirement, however. Deciding between a traditional IRA and a Roth IRA can be difficult, but a few guidelines to help can be very useful.

Traditional IRA
A traditional IRA can provide for a decent retirement and has the following characteristics:

  • Tax deferred- taxes are paid on money withdrawn
  • Tax deductibility depends on income level
  • Available to everyone with no income restriction
  • Funds in the IRA can be used to purchase (Stocks, Certificates of Deposits, Bonds, etc)
  • Withdraw availability (without penalty) begins at age 59 1/2 and are mandatory by age 701/2 (Required minimum distribution)
  • Funds withdrawn before age 59 1/2 are subject to a 10% penalty with few exemptions

Roth IRA
A Roth IRA has the following characteristics:
  • Not tax deferred- taxes are paid on amounts before initial deposit to the IRA account
  • Contributions to the account are not tax deductible
  • Earnings and principal are 100% tax free (all rules / regulations must be followed for this tax status)
  • Funds in the IRA can be used to purchase (Stocks, Certificates of Deposits, Bonds, etc)
  • Available to single filers with income up to $95,000
  • Available to married filers with combined income up to $150,000
  • Principal contributions can be withdrawn at any time. Interest earnings on principal contributions are subject to a 10% penalty if withdrawn before age 59 1/2
  • No mandatory distribution age

Decision Time

One of the main differences between the two IRA options is tax deferred (Traditional IRA) vs. tax free (Roth IRA). With the Traditional IRA money is deposited in the IRA account and money earns interest. Taxes are not paid on the principal amount or the interest earnings amount until withdrawn. This allows for a quicker accumulation of earnings because 100% of the IRA contribution earns returns from day 1.

The Roth IRA works a bit differently. Before money is deposited in the account, taxes are deducted. Once money is earned, a payroll deduction is taken and then deposited in a Roth IRA account. Money is earned on the after taxed dollars. This allows for a slower accumulation of earnings due to the dollars taken upon taxation.

The key concept to think about before making a decision on the type of IRA is when you think you will be in a lower tax bracket apposed to a higher bracket. If you are in a fairly high tax bracket now, then you might consider a Traditional IRA to defer paying taxes on the money invested until later years (lower taxation years). If you are in a low tax bracket now, you may see more earnings potential (with respect to taxation) with a Roth IRA. These decisions are specifically tied to what years you are going to be taxed at a lesser rate.

Ways to avoid the 10% early withdrawal penalty

There are few exceptions to the 10% early withdrawal penalty and require that certain circumstances apply. Read more about the 8 exemptions.

Where can I open an IRA or Roth IRA?

IRAs and Roth IRAs can be opened through a bank or brokerage. If you are interested in holding stocks or bonds in your IRA, it may be wiser to open an account with a broker. Fees do apply and vary by brokerage or banking institution. Scottrade offers a IRA account with significantly lower fees.

IRA Contribution Limits

2002-2004 $3,000 $3,500
2005 $4,000 $4,500
2006-2007 $4,000 $5,000
2008 $5,000 $6,000

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