An in-depth view on Roth vs. Traditional IRA

Since the conception of the Individual Retirement Arrangement (IRA) in 1974 from the Employment Retirement Income Security Act (ERISA), it has helped thousands of individuals to save money for a comfortable retirement. Over the years, the types of IRAs have evolved and increased in number.

Although, this gave contributors more options to choose from, in some ways, it made it hard for some to select which one to use right away. The types of IRA available are SEP IRA, Simple IRA, Self-directed IRA, and the two most popular types: Roth IRAs and Traditional IRAs.

 

How well do you know your IRA?

 

Whether you already have a type of IRA in mind or in the process of choosing one, it is important to know the facts behind each type. The background and particulars of both Roth and Traditional IRAs, two of the most popular types of IRA available, are significant and learning about them will help you to see which one is more applicable to you and your current status.

 

ROTH IRA

History

Roth IRA was created through the Taxpayer Relief Act of 1997. It was named after the late Senator William Roth, its legislative sponsor. The main objective of the introduction of Roth IRA was to relieve some restrictions of the other forms of IRA. Contributions to Roth IRA are not tax-deductible, but it does feature tax-free distributions.

Over the years, the Roth IRA became popular because of its flexible options of age limit and penalty-free early withdrawals.

Mechanism

The mechanism behind the Roth IRA is much like the other types of IRAs except that its contributions are not tax-free. The distributions however are not subject to tax. When it comes to eligibility, it is not age dependent. Anyone can contribute if the age is the factor to consider. With regards to income, your eligibility to invest in a Roth IRA may be restricted because there are certain income limits that you must not exceed in order for you to be qualified to apply for a Roth IRA.

One of its best features is that even after you reach 70½ yrs. old, you can still contribute continuously and no forced withdrawals are required as opposed to other types of IRAs.
This unique feature is best enjoyed by individuals whose goal is to save. You can keep your money in the account for as long as you like and withdraw it anytime you need it.


 

TRADITIONAL IRA

History

Traditional IRA (also called ordinary or regular IRA) came to existence through the Tax Reform Act of 1986. It is the oldest type of IRA and has been an effective retirement savings tool for nearly a quarter of a century. It was originally created in 1975 but huge reforms were made in 1986.


It was originally defined by the IRS as “any IRA that is not a Roth or a simple IRA.”

Mechanism

The top feature of Traditional IRA is its contributions are tax-deductible. The amount to be deducted (full or partial) is limited and dependent on your status. Whether or not you and/or your spouse are covered by a retirement plan at work affects your eligibility to receive tax-benefits.

Eligibility to set-up an account is not measured by the income you earn. Anyone who has income is welcome to contribute to a traditional IRA, but is applicable only up to the age of 70½. After this age, you are not eligible to contribute anymore and the distributions are mandatory. It means that whether you like or not, you need to withdraw your money regularly.

No early withdrawals are also allowed without paying a penalty of 10%.  Although you may enjoy tax benefits while you are still paying your contributions, future distributions, however, are considered income and are subject to tax.

 

ROTH vs. TRADITIONAL IRA: Which one is more flexible?

 

When looking at flexibility when considering Roth IRAs vs. Traditional IRAs, the Roth IRA is deemed to be more flexible. You can withdraw or deposit your money anytime without the burden of penalties, and there no mandatory withdrawals if you still want to continue to keep your money in the account.

If you want to enjoy tax-deductible contributions then Traditional IRA is the best choice, but if saving for the future and enjoying tax-free withdrawals appeal to you more then go with Roth IRA.

Perhaps the more fitting question to compare easily Roth IRAs vs. Traditional IRAs is “Do you want to pay taxes now or in the future?”

 

Call to action.

Leave a comment specifying which IRA you have and why you choose that type of IRA.

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Comments

  1. If you're in the 15% tax bracket max out that ROTH IRA now! It's a no brainer. It's the first thing I would do after ensuring I get my 401k match.
    YFS recently posted..March 2012 Income Report My Profile

  2. I have a Roth IRA because I'm currently in the 15% tax bracket. I'm in graduate school so I haven't even really started my career yet, and I think it's reasonable that I'll have a much higher standard and cost of living by the time I retire and therefore will be in a higher tax bracket. (All else being equal, which I don't think it will, but I still consider it a good bet.) Workplace-sponsored retirement accounts are not available to me right now.
    Emily @ evolvingPF recently posted..Financial Tethers to Our Families of OriginMy Profile

  3. I agree with the last two comments. The Roth IRA provides its owner with more flexibility to do more with their money. I am currently paying into a traditional 401k because my company does not offer a Roth IRA account for its employees. Tear. I have received two raises since beginning work 18 months ago. The last one pushed me up to the next tax bracket. If I continue on this pace I will be paying a much higher tax rate when I withdraw the funds in retirement, then I would have if they were already taxed Companies should begin to offer both, and perhaps move to phasing out the traditional altogether. I am however, not smart enough to think of the repercussions that would cause, and how the switch would occur. What do you people think?
    Erica recently posted..43 Articles With Advice for Borrowing Against Your Life InsuranceMy Profile

  4. I think that Roth IRAs are the better choice because of their felixiblity. I know that there are some nice offers from the other side as well. but in this unsecure world nowadays, I think felixibility is very important.
    Julie recently posted..crowns on teethMy Profile

    • Traditional IRA's have flexibility has just as much flexibility if you need the funds out through qualified distributions. Keep in mind this is a retirement account, so in my mind you need to have all your basis covered prior to investing. If a person has an adequate emergency. fund then flexibility or raiding the IRA shouldn't be an issue
      YFS recently posted..One Night, Big Belly! My Profile

  5. It often sounds simpler than it really is, Roth of Traditional? I have a Roth IRA. This is because I believe my tax level will increase at the time my distributions kick in. Naturally, to avoid paying higher taxes later I thought it best to pay them now. Plus, as stated in the article, the flexibility and relaxed withdrawal policies it just seemed more "user friendly" to me. It seems to me that most people believe they will accrue wealth or be paid more over their lifetime than when they started out. This in turns raises their taxes because their income is higher, so why doesn't everybody use the Roth over the Traditional? Am I missing something?
    Jason recently posted..10 Financial Reasons Why Whole Life Insurance Isn’t BetterMy Profile

    • Here is one reason not to use the Roth. Say you have a high savings rate, 50%. And your current income puts you in a high (28%+) marginal tax bracket. But, your expenses are in say the 15% marginal tax bracket. This means, you only need an income in the 15% marginal tax bracket and during distributions, will be paying 15% on money from retirement accounts.

      So, the question isn't, "should you pay taxes now or later," it truly is, "will your taxes be higher now or at distribution." We have demonstrated, with actual math, how the Roth IRA and TIRA are the same if tax rates are the same on our blug. We all have our own conspiracy theories about what taxes will do, and we believe the middle class will be relatively safe from significant tax hikes going forward. That, and knowing we will go down a couple of brackets in retirement makes the roth a less than optimal choice for us. We also don't need the flexibility, mainly because we have such a hefty emergency fund (1.5 years). Combine that with a significant portion (from when we made less) of our portfolio is in Roth money.

      Yes, you are missing something.
      Bichon Frise recently posted..You are not BuffetMy Profile

      • Well said! What are you thoughts on high income people who max out their 401k's, but have the option (money) to max out their IRA's. Would you opt for the Traditional IRA or ROTH IRA (Conversion)?
        YFS recently posted..One Night, Big Belly! My Profile

  6. Every country is a bit different but we have much the same in the UK. Except some jobs particularly in banks and with better employers will build a fund that pays according to the final salary. Typically this is on 1/80ths so if you work for 40 years you retire on half pay – and have a tax-free lump sum as well. I don't know whether that exists in the US.
    John@MoneyPrinciple recently posted..Five things older people have and young people…My Profile

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