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Traditional IRA versus a Roth IRA

April 6, 2009

This year you have told yourself that you are going to start saving for retirement. You’d like to open an IRA, or Individual Retirement Account, but which kind of an IRA should you open? You have heard of two kinds, a traditional IRA and something called a Roth IRA, and you have no idea what the difference is between them.

An IRA is defined as a personal retirement plan whereby a limited amount of annual earned income may be saved or invested in specially designated accounts.

Traditional IRAs

Contributions to a traditional IRA are completely tax deductible, unless your income exceeds a certain level, where phase-outs begin. Although you can still make a contribution, if you are in the higher tax brackets, you will be unable to deduct those contributions on your tax return. You can begin to take distributions from a traditional IRA at the age of 59 ½ without penalty and you must start taking distributions by 70 ½, even if you don’t want to. If you end up having to withdraw money prior to the age of 59 1/2, you will generally have to pay a 10% penalty. When you receive money from this kind of IRA, be prepared to pay taxes, because although your money has been growing tax free, now that you have withdrawn some, the funds become taxable income. There are no income restrictions when it comes to contributing to a Traditional IRA.

Roth IRAs

With a Roth IRA your contributions are not deductible on your tax return, however, all earnings and your principal investment are 100% tax free when it comes time for withdrawal. Unlike a traditional IRA, there are no age restrictions with a Roth IRA. You decide when and if you want any of the funds and principal contributions can be withdrawn anytime without penalty. At present, there are restrictions that could bar you from opening a Roth IRA. For example, in 2009, if you are single, you cannot earn more than $101,000 annually, if you are married, you and your spouse must have a combined income of $166,000 or less, otherwise you will have to opt for a traditional IRA, where the income restrictions are more lenient. If you do open a Roth, keep in mind that if you should subsequently receive a significant increase in salary, you may not be able to continue to make contributions. Contributions are also limited to the amount of your earned income during the year, so if you only earn $4,000, you can only contribute $4,000 or less to your Roth. At this time, the maximum you can contribute to a Roth is $5,000/year, or $6,000 if you are 50 years or older.

Converting a Traditional IRA to a Roth

In 2009, to qualify for a Roth conversion, your adjusted gross income may not exceed $100,000, whether you are single or married.

However, one important thing to keep in mind, if you only qualify to open a traditional IRA or already have one, in 2010 the income restrictions on Roth IRA conversions expire, meaning anyone will be able to convert the funds in a traditional IRA to a Roth. Despite the fact that you will have to pay taxes on the amount you convert, the 2010 conversion amount may be included as taxable income in 2011 and 2012. The ability to spread the possible heavy tax burden over more than one year may make it possible for you to take advantage of this fabulous opportunity.

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Traditional IRA versus a Roth IRA

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