What Is the Difference Between an Individual IRA and a Roth IRA?

An IRA is an Individual Retirement Account. IRAs help you save money for your retirement by deferring the payment of income taxes on your retirement savings. This deferment increases your retirement savings because the money that would have gone to taxes goes toward your retirement savings instead to earn interest as you invest. Before investing in an IRA, make sure you understand the difference between an individual IRA and a Roth IRA.

Types

An individual IRA refers, broadly, to any number of IRA accounts that you may invest in. This includes traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs. A Roth IRA is a particular kind of IRA that allows after-tax contributions to the account in exchange for tax-free withdrawals from the account.

Function

Roth IRAs function by deferring income tax during your lifetime. Roth IRAs work by accepting after-tax contributions. In exchange for paying tax on contributions, the IRA allows tax-free withdrawals. Other individual IRAs do not allow tax-free withdrawals. Instead, pretax contributions are made to the account and all withdrawals are taxed at ordinary income tax rates.

Benefits

The benefits of a Roth IRA are that you may withdraw your contributions to the account at any time during your lifetime without a penalty. In retirement, you don't have to worry about what current tax rates are, since all withdrawals are tax-free. Ordinary individual IRA accounts are beneficial for accumulating a large total retirement savings, since all contributions are pretax.

Disadvantages

The disadvantage to a Roth IRA is that you can only fund the account with after-tax dollars. This means that, when compared to other individual IRAs, more of your income must go toward funding the Roth, since part of the contribution amount is lost to taxation. The disadvantage to other individual IRAs is that the IRA account is taxed at ordinary income tax rates when you start withdrawing money from the account. This means that the more money you accumulate in your IRA, the more in taxes you will pay. If tax rates rise in the future, you could have less retirement income than a Roth would produce.

Considerations

If you think that tax rates will be lower in the future, or that you'll be in a lower income tax bracket, a non-Roth IRA may be suitable for you. Even though you may pay income tax on distributions from traditional individual IRAs, you might have more income than a Roth if your tax rate is low enough. If you believe tax rates will rise in the future, then a Roth IRA would be ideal.

References

• "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
• "The Calculus Of Retirement Income"; Moshe A. Milevsky; Cambridge University Press; 2006
• "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004