Individual Retirement Accounts are tax-advantaged investment accounts that are intended for long-term savings. Roth and Traditional IRAs share some characteristics, but their contributions and withdrawals are treated differently for tax purposes, and they have different rules regarding mandatory distributions. Roth IRAs also have special provisions regarding when withdrawals may be taken without penalty.
Contributions
You can make a contribution to either a Roth or a Traditional IRA by your tax filing date, plus extensions. Usually, this means you must make your IRA contribution by either April 15 or October 15, depending on if you filed for an extension. You are entitled to a tax deduction for your contribution to a traditional IRA, subject to IRS limitations, but you do not get this deduction for Roth contributions. Traditional IRA contributions are said to be pre-tax, or tax-deductible, while Roth contributions are known as after-tax or non-deductible contributions.
Contribution Limitations
For 2010, contribution limits for both accounts are limited to the lesser of $5,000 or your taxable compensation, unless you are age 50 or older, in which case you may contribute an additional $1,000 for a maximum of $6,000. While you can contribute to a Roth IRA for as long as you live, Traditional IRA contributions must end once you reach age 70 1/2. Roth contributions are further limited based on your modified adjusted gross income (MAGI). For 2010, single filers cannot contribute to a Roth with a MAGI over $105,000, and couples are restricted at a MAGI of $167,000.
Distributions
As contributions to a Traditional IRA are made on a pre-tax basis, distributions are taxable at ordinary income rates. However, since Roth IRAs are funded with money that has already been taxed, withdrawals are generally tax-free. Part of the process of determining whether to contribute to a Traditional or Roth IRA is estimating what your tax bracket will be at retirement versus your tax bracket at the time of contribution.
Required Minimum Distributions
If you own a Traditional IRA, you are required to take annual minimum distributions (RMD )from the account upon reaching age 70 1/2. The amount of the distribution is computed by dividing your year-end account value by your life expectancy, as found in IRS tables. Failure to take your RMD in any year results in an excise tax of 50 percent of the amount that should have been distributed. As Roth distributions are not taxed, the IRS does not require RMDs from Roth IRAs.
Early Withdrawals
For both Traditional and Roth IRAs, if you withdraw funds before you reach age 59 1/2, you are assessed a 10 percent early withdrawal penalty by the IRS. Exceptions to this rule for both types of accounts include withdrawals due to death, disability, excess medical expenses, the first-time purchase of a home or higher education expenses.
Five-Year Holding Period
In order to qualify for tax-free status, a Roth IRA withdrawal must meet an additional holding period requirement that does not apply with Traditional IRAs. Specifically, you cannot take a distribution unless it has been at least five years from the beginning of the year that you originally established and contributed to your Roth. Distributions taken within this five-year period are subject to a 10 percent early withdrawal tax, and earnings on these distributions are also subject to ordinary income tax.
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