An Individual Retirement Account is a long-term, tax-advantaged savings account designed to encourage Americans to save for retirement. Traditional and Roth IRAs are two of the main types of IRAs. While they both provide tax savings for individuals, they accomplish these savings in very different ways, the differences lie primarily in the way in which contributions and distributions are taxed. Determining which account type is better for your saving needs may require the assistance of a tax or financial adviser.
Taxation
The primary difference between Roth and Traditional IRAs lies in their tax benefits. With both types of accounts, you won't pay any tax on the earnings in your account as they accrue. However, with a Traditional IRA, your distributions will be taxable at ordinary income tax rates, while your Roth distributions will generally be tax-free. If you contribute to a Traditional IRA, you may receive a tax deduction on your contribution, whereas with a Roth IRA, contributions are never deductible.
Limitation on Contributions
For 2010, both Traditional and IRAs have the same contribution limit of the lesser of $5,000 or the amount of your taxable compensation. If you are age 50 or older, you are permitted to contribute an additional $1,000. Your Roth contribution may be limited based on your filing status and income levels. If you are a single filer with a modified adjusted gross income of $120,000 or over, you cannot make a Roth contribution. The same applies if you are a couple with a MAGI of $176,000 or more. Contributions are phased out for single incomes above $105,000, and for couples with income above $166,000. There are no income limitations on contributions to a Traditional IRA.
Deductibility of Contributions
While Roth contributions are never tax-deductible, the deductibility of your Traditional IRA contribution is based on a combination of your filing status, income and whether or not you are covered by an employer-sponsored retirement plan. IRS Publication 590 provides a complex matrix outlining the specific deductibility of Traditional IRA contributions. Generally speaking, if you are not covered by an employer-sponsored plan, you may deduct the full amount of your Traditional IRA contribution. If you are a single filer with a MAGI of $65,000 or over, or if you are married filing jointly with a MAGI of $109,000 or more, none of your contributions are deductible if you are covered by a plan at work.
Required Minimum Distributions
Once you reach the age of 70 1/2, the IRS requires you to begin taking required minimum distributions (RMD) from your Traditional IRA. The amount of your RMD is calculated by dividing your year-end account value by your life expectancy. Your life expectancy is computed by using one of three tables in Appendix C of IRS Publication 590, and it varies depending on your age and the age of your beneficiary. No minimum distributions are required at any time from a Roth IRA.
Penalties and Exceptions
For both Roth and Traditional IRAs, if you take a withdrawal before you reach the age of 59 1/2, you are subject to a 10 percent early distribution penalty. There are a number of exceptions to this penalty, including distributions you take for excess medical expenses, higher education expenses, disability withdrawals, and expenses related to the first-time purchase of a home, up to $10,000. For Roth IRAs only, if you take a withdrawal within the five-year period after you establish the account, you must pay a 10 percent penalty plus ordinary income tax on the earnings portion of your distribution. For Traditional IRAs, failure to take your RMD results in a 50 percent "excess accumulations" penalty.
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