Traditional IRA vs. Roth IRA
Anyone wanting to get a good understanding of retirement plans should have lots of time on their hands, some good reading glasses, and some aspirin. The number of retirement plans available is overwhelming; there are individual retirement plans (IRA’s), and employer-sponsored retirement plans (Defined Benefit, Defined Contribution, 401K’s, Profit-Sharing plans, ESOP plans, Simple plans, Money-Purchase pension plans, and SEPs.)
Let’s take a look at the two Individual Retirement Plans (IRA’s), and see how they compare.
Traditional Individual Retirement Plan (IRA)
Regular IRA’s were created in 1975, and are no longer offered. Traditional IRA’s have been around since 1986. They have always been a popular investment product, because the contributions made (up to $5,000 in 2010; $6,000 if you are over 50) are deductible from your income for tax purposes. If you earn $85,000 in 2010 and contribute $5,000 to your IRA, your taxable income drops to $80,000. The $5,000 drop saves you not only the tax on the $5,000 ($1,400 @ 28%), it drops you to a 25% marginal rate which can save you up to $14,000 in taxes, depending on your filing status and other factors.
Traditional IRA’s are a good tactical maneuver if you want to drop into a lower tax bracket. Since no taxes have been paid on the deposit, you will have to pay taxes when the money is withdrawn. Withdrawals must be made starting at age 70 ½. When withdrawn, the money is taxed as if it was ordinary income. Most retirees are in a lower tax bracket at retirement age, so the theory is that the withdrawal will be taxed at a lower rate than if taxes were paid prior to deposit.
Roth IRA
Roth IRA’s were established in 1997. The tax structure of a Roth is substantially different from that of the Traditional IRA. Taxes on contributions made to a Roth are paid prior to depositing the money. Consequently, the account owner has better access to his account funds, and the investment of funds can be done either by an account custodian or the account owner (self-directed). Further advantages of a Roth IRA over a Traditional IRA are:
- Direct contributions can be withdrawn tax-free at any time
- Up to $10,000 in earnings can be withdrawn for the purchase of the account owner’s first home
- Assets can be passed on to heirs
- There are no age-based distribution rules. Funds can be withdrawn once the account is five years old.
Growth is Not Guaranteed
Both the Traditional IRA and the Roth IRA are investment-based retirement accounts. The key word here is “investment”. Investment’s don’t always earn money, even when they are invested in blue-chip, stable companies. Markets and economies can crash, and your investment could suffer.
Each person’s circumstances will vary, and it is difficult to choose wisely unless all of the circumstances are known. Choosing an IRA account is always a wise decision; which one is best for you is between you and your financial advisor.
