Although Roth and Traditional Individual Retirement Accounts share some of the same features and benefits, they are taxed in very different ways. Both accounts are designed to provide long-term, tax-advantaged retirement savings for investors, as you do not have to pay tax on account earnings as they accrue. However, the additional tax benefits of the Roth IRA are generally realized only upon distribution, while Traditional IRAs offer benefits at the time of contribution.
Contribution Limits
For 2010, contribution limits are the same for both Traditional and Roth IRAs, at the lesser of $5,000 or the extent of your taxable compensation for the year. You can contribute an additional $1,000 if you are age 50 or older. Additionally, if you participate in a 401(k) and your employer went bankrupt during the year, you are allowed to contribute $8,000.
Restrictions on Contributions
While you can contribute to a Roth IRA indefinitely, you must stop your Traditional IRA contributions once you reach the age of 70 1/2. However, Roth IRAs do have income limitations on contributions that Traditional IRAs do not. These limitations are based on your modified adjusted gross income and filing status. Specifically, if you file taxes jointly with your spouse and have a modified adjusted gross income of $176,000 or higher, you cannot contribute to a Roth. The same applies for single filers with a MAGI of $120,000 or higher. Contribution limitations for other filing statuses, along with phase-out ranges for contributions, can be found in IRS Publication 590.
Deductibility of Contributions
As Roth IRAs are funded with after-tax dollars, you are not allowed a tax deduction when you contribute. Traditional IRAs, on the other hand, are funded with pre-tax dollars, meaning you are generally allowed to take a tax deduction at the time you contribute. If you are not covered by a retirement plan at work, you can generally deduct the full amount of your contribution. However, if you or your spouse are covered by an employer-sponsored plan, the deductibility of your contribution is affected by the amount of your income. IRS Publication 590 provides a matrix to help you compute the deductibility of your IRA contribution for all circumstances.
Distributions
Distributions from Traditional IRAs are taxable at ordinary income rates, while those from Roth IRAs are generally tax-free. However, if you take a withdrawal from a Roth IRA within the first five years since you funded the account, the earnings on that withdrawal are taxable at ordinary income rates. With Traditional IRAs, you are required to take minimum distributions once you reach age 70 1/2, a requirement that does not extend to Roth IRAs. The amount of the required minimum distribution, or RMD, is determined by your year-end account value and the life expectancy of you and your beneficiary, as determined by IRS tables. Appendix C of IRS Publication 590 provides worksheets and three life expectancy tables to help you compute your RMD, which changes every year as you age and your account value fluctuates.
Penalties
Distributions from both Traditional and Roth IRAs generally incur a 10 percent early withdrawal penalty if you take them before you reach age 59 1/2. If your distribution is due to death, disability, higher education expenses, excess medical expenses, or the first-time purchase of a home, up to $10,000, then you can generally avoid the 10 percent penalty. If you take a Roth distribution within the first five years, that distribution is also subject to a 10 percent early withdrawal penalty. If you do not take your RMD from your Traditional IRA, you will owe a 50 percent penalty on the amount you failed to withdraw.
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