What is a Traditional IRA?
A traditional Individual Retirement Account (IRA) is an investment (stocks, bonds, mutual funds, CDs, etc.) wherein your contributions serve to reduce your taxable income (deductible) the year you record your contributions.
The earnings from an IRA grow on a tax-deferred basis until you begin to take qualified distributions (after age 59-1/2).
Contributions and earnings are added to your ordinary income at the time they are distributed (withdrawn) and are therefore fully taxable based on your tax bracket at the time of the withdrawals.
Minimum distributions are required at age 70-1/2. Distributions taken prior to your qualifying age will incur taxes and a 10% early withdrawal penalty.
What is a Roth IRA?
A Roth IRA is an individual retirement account wherein your contributions do not serve to reduce your taxable income (non-deductible) in the year they are recorded.
In other words, you will have already paid income taxes on your contributions based on your tax bracket at the time of each contribution.
The earnings from a Roth IRA grow tax-free, so qualified distributions (withdrawals) are not taxed.
The main advantage to a Roth IRA is that once you have kept a contribution for the "seasoning period" (5-years the last time I checked), you can withdraw the contribution without tax (you already paid the taxes) or penalties.
The main disadvantage of a Roth is that your contributions will not lower your tax liability for the year they are recorded.
What Purposes are Served by a Roth IRA?
The main purpose of a Roth IRA is to enable you to withdraw funds from your retirement account during your retirement without having to pay any tax on the withdrawals -- including the earnings.
The second purpose of a Roth is to enable you to leave your retirement funds for your heirs since a Roth doesn't have the minimum distribution requirements imposed by a Traditional IRA.
A third potential purpose of a Roth IRA is if you believe you will be in a higher tax bracket after retirement, paying taxes on your contributions now might make more sense.
No Crystal Ball?
Consider a Roth
I know first-hand how expensive an early withdrawal from a traditional IRA can be. It's no fun to see money evaporate into thin air.
So unless you know with absolute certainty that you will never have to make an early withdrawal from your IRA to cover an unexpected financial emergency, I would think twice about choosing a traditional IRA.
In my opinion, your money is safer from stiff penalties if you pay the taxes up front by choosing to fund a Roth IRA (the economic meltdown of 2009 is a case in point). After all, if you have the funds to contribute to an IRA in the first place, then you also have the funds to pay the taxes on them upfront.
How a Roth Versus Traditional IRA Comparison is Made
To compare Roth versus Traditional IRAs, we must account for the differences in tax payments.
Since contributions to Roth IRAs are not deductible from taxable income, then to make, say a $1,000 contribution, you must pay the taxes on the $1,000 out of your other income.
So if you are in a 25% tax bracket, this means you will need to pay $250 in taxes, plus contribute the $1,000.
On the other hand, if you contributed the $1,000 to a Traditional IRA, you would not need to pay the $250 in taxes until you withdraw the contribution.
Therefore when comparing the two, we assume that if you chose to fund the Traditional IRA, you would then invest the $250 tax savings that would have otherwise gone to pay taxes on the Roth IRA contribution.
Quick Reference Guide
Here is a quick-reference chart highlighting the differences between a traditional IRA and a Roth IRA:
|Contributions are ...||Deductible||Non-deductible|
|Earnings are ...||Tax Deferred||Tax Exempt|
|Qualified withdrawals are ...||Fully Taxable||Tax Free|
Given the above differences, comparing the two becomes somewhat complicated. Luckily, you have free access to the calculator on this page that greatly simplifies the comparison process.
Please keep in mind that investing and saving for retirement is only half the equation. After all, if your retirement debt payments add up to your retirement income, you will still be left without a retirement income.
Therefore your retirement might be better served by using the extra money for paying off high interest debt (Invest in Your Debt Calculator).