- Both a traditional and Roth IRA provide a tax shelter for your savings, but in different ways. Contributions to a traditional IRA are exempt from taxes, and profits are not taxed as long as they remain in the account. When funds are withdrawn after retirement, they are subject to taxation. By contrast, contributions to a Roth IRA are not tax deductible. However, when funds are later withdrawn, they are tax exempt, including any profits.
- Each type of IRA is governed by a different set of regulations. In a traditional IRA, funds cannot be withdrawn before retirement except for short periods (60 to 90 days depending on the reason) without paying a penalty plus any taxes on the funds. Anyone can open an IRA if they have earned income and are under 70-1/2 years of age (the age limit does not apply to Roth IRAs). You can contribute up to a certain amount of money each year (the amount changes; in 2008, it was $6,000, for example). Roth IRAs are distinctive in that they can be set up so you may withdraw the funds after just a few years instead of waiting for retirement. See Resources for a link to download the IRS Publication 590, which lists the full regulations governing IRAs.
- The traditional IRA is used almost exclusively to save for retirement. It is appropriate if you expect to be in a lower tax bracket after retirement because the tax deduction on contributions will be greater. Roth IRAs have multiple uses. As a retirement account, they are best if you expect to be in a higher tax bracket after retirements. In addition, because they may be opened for just a few years, they are effective accounts for saving for college costs or in preparation for buying a home.
- For people who do not have 401K plans through their employers, Roth or traditional IRAs offer an alternative. Other people use them to add to savings for retirement in addition to what is in their 401K accounts. IRAs are flexible and can encompass a wide variety of investments, ranging from buying bank CDs to extensive portfolios of stocks and bonds.
- Selecting the investments in an IRA is just as important as choosing which kind of IRA you need. For maximum safety, you may want to open an IRA with your bank and purchase CDs. Many banks charge no fee for this type of IRA investment, but the rate of return is low. You can also set up an IRA through a mutual fund (or purchase mutual fund shares through your bank or a brokerage firm). If you wish to invest in stocks or bonds, you will need to open an IRA with a brokerage firm or at a bank that allows this type of investment. Whatever you decide, always research any mutual funds, stocks or bonds carefully before investing your money. IRS regulations allow the same types of investments for traditional and Roth IRAs. However, account providers (your bank, for example) may restrict an IRA account to certain types of investments.
