Roth and Traditional IRAs are both long-term Individual Retirement Accounts that offer tax advantages to you as an investor. If you fail to follow Internal Revenue Service rules regarding these accounts, you may be assessed taxes and penalties. Both types of accounts function in a similar manner, but they have very different rules regarding contributions and distributions. You may wish to consult a tax or investment adviser to help you determine which type of IRA might be more appropriate for you.
Contributions
Contribution limits to Roth and Traditional IRAs are the same, at the lesser of $5,000 or the extent of your taxable compensation. If you are age 50 or older, the IRS allows a "catch-up" contribution of an additional $1,000. These amounts are reviewed annually by the IRS and subject to change. While Roth contributions can continue regardless of your age, you are not permitted to make Traditional IRA contributions once you reach the age of 70 1/2. However, your Roth contributions may be limited by your modified adjusted gross income (MAGI). If you are a single filer, you cannot contribute to a Roth if your MAGI exceeds $105,000, and the same limitation applies if you are a couple with a MAGI exceeding $167,000. Your contributions to a Traditional IRA are not limited by your MAGI.
Distributions and Taxation
Your contributions and earnings in a Traditional IRA grow tax-deferred until withdrawal, at which point they are taxable as ordinary income. Your Roth IRA contributions and earnings, on the other hand, are generally tax-free, even at distribution. When you reach age 70 1/2, you are required to take minimum distributions from your Traditional IRA, based on your account value and your life expectancy. IRS Publication 590 provides tables and worksheets to help you compute your life expectancy and the amount of your required minimum distributions (RMDs). Roth IRAs do not have RMDs at any time.
Deductibility of Contributions
Your Roth IRA contributions can be withdrawn tax-free because they are already taxed when you make your contribution. Unlike with a Traditional IRA, where your contributions may be tax-deductible, you must fund your Roth IRA with after-tax dollars. The deductibility of your Traditional IRA contributions is determined by your filing status and whether you are covered by an employer-sponsored retirement plan at work. To calculate the deductibility of your Traditional IRA contributions, you must consult IRS Publication 590, which provides a matrix showing the permissible deduction for your contribution.
Five-Year Roth Window
While most withdrawals from an Roth IRA are tax-free, if you take a distribution in the five-year period after establishing the account, you will have to pay a 10 percent early withdrawal penalty. Additionally, the earnings on the amount you withdraw must be included in your taxable income for the year.
Penalties
Failure to take your RMD from your Traditional IRA will result in a 50 percent penalty on the amount you should have withdrawn. For both Roth and Traditional IRAs, distributions before you reach the age of 59 1/2 are assessed a 10 percent early withdrawal penalty. Additionally, the IRS levies a 6 percent penalty on both types of IRAs for contributions made in excess of the allowed amount.
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