What is the Difference Between a Traditional and Roth IRA?

I’m a big fan of the IRA or Individual Retirement Arrangement when it comes to saving for retirement. But I’ve found that many people are unclear about IRAs; they aren’t sure who can have one or how an IRA really works. If you’re a more experienced investor, you may know the answer to those questions but still be uncertain about whether a traditional or a Roth IRA is right for you. I’ll help you with the answers to those questions in this and in the next article.

What is an Individual Retirement Arrangement (IRA)?

Okay, let’s start with the basics. A fundamental concept to understand about an IRA (or any retirement account, for that matter) is that it’s not an investment. An IRA is an account for your investments. Think of it like your house or apartment—it’s a shelter that protects you, but it’s not you. In a similar way, an IRA is also a shelter that protects your investments while they’re owned inside the account.

What Can You Own Inside an IRA?

You can put just about any investment in an IRA, such as stocks, bonds, exchange traded funds (ETFs), mutual funds, and CDs. There are even special kinds of accounts called self-directed IRAs that allow you to invest directly in less main-stream investments, like real estate and businesses. But I’m just going to focus on traditional and Roth IRAs here.

What is a Traditional IRA?

A traditional IRA is available to anyone who’s younger than age 70½ and has earned income. Earned income could come from your job, business, taxable alimony receipts, or even from your spouse if you’re married and don’t work. For 2010, you can contribute an amount equal to your earned income up to $5,000. However, if you’re age 50 or older you can make an additional “catch up” contribution of $1,000, for a total of $6,000.

What are the Benefits of a Traditional IRA?

If you, or a spouse, don’t have a retirement plan at work, like a 401(k) or a 403(b), you can deduct all your IRA contributions from your income. That means you don’t pay tax on the amount you contribute until you withdraw money from the account during retirement. Here’s an example: Let’s say you’re 30 years old, earn $35,000, and file taxes as a single person. If you max out your traditional IRA, by contributing $5,000 in 2010, then you only have to pay tax on $30,000—not on $35,000. The $5,000 IRA contribution gives you a tax savings of just about $850! So every dollar that you contribute to a traditional IRA lowers the amount of money that you’re taxed on in the current year. If you do have a retirement plan at work, you can still max out a traditional IRA, but some or all of your contributions may not be tax deductible, depending on your income.

Another great benefit of a traditional IRA (whether you have a retirement plan at work or not), is that when your investments grow in value, you’re not taxed on their growth each year. When you have a regular, non-retirement brokerage account, you do have to pay tax each year on income from certain types of investments, like CD dividends and bond interest. So, with a traditional IRA, you defer paying taxes on both your contributions and earnings until you withdraw money in the future. 

Distributions from a traditional IRA can be made once you reach the official retirement age of 59½, and they have to be made after you turn 70½. If you get antsy and decide to take money out of a traditional IRA before you’re 59½, in most cases, you’ll be hit with a 10% early withdrawal penalty plus ordinary income tax on the amount.

What is a Roth IRA?

Now, let’s switch gears and cover the Roth IRA. Unlike the traditional, the Roth is only available to those who make under a certain amount of money. I’ll go over the income restrictions in a bit.

How much you can contribute to a Roth IRA is the exact same as with a traditional IRA. As I mentioned, it’s an amount equal to your earned income up to $5,000 or up to $6,000 if you’re age 50 or older for 2010. With a Roth IRA there’s no age deadline for making contributions—you can put money in it for the rest of your life. Remember that for a traditional IRA, you can’t make contributions after you reach age 70½.  

What are the Benefits of a Roth IRA?

The taxation of contributions to a Roth works just the opposite from a traditional IRA, because contributions are not deducted from your gross income. Another way of saying that is that Roth contributions are not tax-deductible. Let’s go back to my earlier example: You’re 30 years old, earn $35,000 and contribute $5,000 to a Roth IRA. In this case, you’d have to pay tax on your full earnings of $35,000. But the really great thing about a Roth IRA is this: that’s where your taxation ends. When you retire and begin to take money out, you won’t owe a penny in taxes. You don’t even have to pay taxes on the growth in the account that accumulated over many years! With a Roth IRA, your investments are allowed to grow completely tax-free, which is a really big deal.

Additionally, there’s no requirement to take minimum distributions at 70½, as there is with a traditional IRA. The money can sit there forever, which makes the Roth IRA a nice way to pass money on to your heirs. However, if you take money out of a Roth IRA before you’re 59½, you have to pay a 10% early withdrawal penalty on just your earnings.

What are the Income Restrictions for a Roth IRA?

Having a retirement plan at work has no bearing on a Roth IRA. However, as I mentioned above, you can’t contribute to a Roth IRA if you make too much money. The upper income limit depends on your tax-filing status and modified adjusted gross income as follows:

• Single: $120,000

• Head of Household: $120,000

• Qualifying Widow(er): $120,000

• Married Filing Separately: $120,00 (if you did not live with your spouse at any time during the year, otherwise $10,000)

• Married Filing Jointly: $177,000.

How to Start an IRA

It’s easy to open up a traditional or Roth IRA at an online brokerage like ShareBuilder, E*Trade, or Scottrade. There’s also another way you can start a Roth IRA: Convert all or a portion of a traditional IRA into a Roth account. I covered Roth conversions in a previous post, so be sure to read that article for details about the new 2010 conversion rules.

Now that we’ve covered the basics of traditional and Roth IRAs, in part two of this topic we’ll get a little more advanced. I’ll give you tips for figuring out which type is right for you and tell you the best types of investments for each one.  And in part three we’ll delve even deeper into the pros and cons of both IRA forms.  Lastly, If you’re thinking about converting from one Roth plan to another, please read my Quick Tip on how Roth conversions are taxed.

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