Wednesday, December 29, 2010

Traditional IRA vs. Roth IRA - Which is Better?

To open a Roth IRA or Traditional IRA, that is the question. Both IRAs are great ways to save, but each offers different advantages with potentially large financial consequences. The biggest difference between the Roth and Traditional IRA is in the way the government treats the taxes.
If you earn $50,000 and put $2,000 in a Traditional IRA, you can deduct the $2,000 from your income taxes. This means you only have to taxes on $48,000 to the IRS. When you reach the age of 59 1/2, you can begin withdrawing the money, but you have to pay taxes on any capital gains, interest, dividends, etc., that were earned over the years.
If you put the same $2,000 in a Roth IRA, you do not get the income tax deduction. At retirement age, you are able to withdraw the money 100 percent tax-free. If you need the money, you can withdraw it at any time, however you will pay a 10 percent penalty on any income earned. In most cases the Roth IRA is the way to go.
There are eight exemptions to avoid a penalty for early withdrawal.
  1. Permanent disability of the IRA owner.
  2. Death of the IRA owner.
  3. If you are seriously ill or injured and require prolonged or expensive medical care, Uncle Sam will waive the early withdrawal fee on the condition the expenses are in excess of 7.5 percent of your adjusted gross income.
  4. Withdrawals are used to pay for a first-time home purchase.
  5. Certain higher education costs for you, your spouse, children or grandchildren can be withdrawn penalty-free. However, you may still owe federal income tax, so you should check the IRS tax code.
  6. The money is used to pay back taxes to the IRS after a levy has been placed against the IRA.
  7. If you are out of a job and have been paid unemployment for more than 12 weeks, you can use the money to pay medical insurance premiums.
  8. You reach the retirement age of 59 ½. 
There is one catch to these qualifying exemptions; the holder of an IRA is subject to a five year waiting period (measured in tax, not calendar, years). An investor could not, for example, deposit $3,000 in their IRA this year and withdrawal it next year penalty-free even if it would otherwise qualify as an exemption.

The following is a quick summary of each IRA.

Traditional IRAs
  • Tax deductible contributions (depending on income level).
  • Withdraws begin at age 59 1/2 and are mandatory by 70 1/2.
  • Taxes are paid on earnings when withdrawn from the IRA.
  • Funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.).
  • Available to everyone; no income restrictions.
  • All funds withdrawn (including principal contributions) before 59 1/2 are subject to a 10% penalty (subject to exception).
  • Roth IRA Profile
  • Contributions are not tax deductible.
  • No mandatory distribution age.
  • All earnings and principal are 100% tax free if rules and regulations are followed.
  • Funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.).
  • Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).

Both IRAs can be opened through a bank or brokerage house. Opening fees differ, but are dramatically less than other types of investment accounts.