IRA Vs. Roth IRA Model

Which tax shelter should you choose, a traditional IRA or a Roth IRA?

If you fail to make intelligent choices when planning for your retirement, you could end up with significantly less than you had hoped for due to taxes. An individual retirement arrangement, or IRA, is a tax shelter created by government that could help to reduce the impact of that taxation. IRAs can invest in a variety of financial products, but before you invest in one, you will want to know the difference between the traditional IRA and the Roth IRA.

Types

There are two types of IRAs. A traditional IRA allows you to make pre-tax contributions by deducting the contributions made in any given year from that year's gross income. In exchange for this deduction, you will pay ordinary income taxes when you withdraw your savings during retirement. A Roth IRA does not allow any deduction for contributions made to the plan. Instead all of the money withdrawn during retirement is tax-free.

Benefits

Traditional IRAs allow you to grow your savings using pre-tax dollars through a deduction made on your tax return for the contribution. This may allow you to grow your savings into a larger total amount when compared to a Roth IRA. If you're looking for a larger lump sum of money, the traditional IRA may give you more potential for that than a Roth IRA. Roth IRAs may give you more net income during retirement because the distributions are tax free. When compared to a traditional IRA, the main factor in determining what will be the better choice is what tax rate you will be in during retirement. Higher future tax rates favor a Roth IRA, while lower future tax rates favor traditional IRAs.

Features

A feature found in both traditional and Roth IRAs is the ability to invest in a variety of financial products. Mutual funds, individual stocks, bonds, and even real estate can be used to grow your retirement savings. Roth IRAs have a feature not available for traditional IRAs, however, that allows you to withdraw your contribution amount at any time with no penalty. Interest earnings are still subject to a penalty if they are withdrawn prior to age 59 1/2.

Disadvantages

A significant drawback to traditional IRA plans is that that access to your savings is severely restricted. Early withdrawals, prior to age 59 1/2 are not allowed without a penalty unless you make withdrawals according to IRS rule 72(t), and you must withdraw the money after age 70 1/2 or face another penalty. Roth IRAs do not allow you to withdraw your interest earnings without a penalty prior to age 59 1/2. Roth IRAs also typically have lower contribution limits when compared to traditional IRAs. You must wait 5 years after starting your Roth IRA to make withdrawals of investment earnings.

Considerations

Before contributing to any IRA plan, understand your retirement objectives and goals. If you think tax rates will increase, or that your personal tax rate will be higher during retirement, then you will want to choose a Roth IRA. If you expect your future tax rate to be lower during retirement, a traditional IRA may be more suitable for maximizing your retirement income.

References

• "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
• "Ernst & Young's Personal Financial Planning Guide, 5th edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
• "Practicing Financial Planning for Professionals, practitioner's 10th edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
• http://www.irs.gov: IRS Publication 590