Both the Roth and Traditional IRA’s are a beneficial way to save money for retirement. Additionally, there are 2 main IRA options available so it is important to pick the plan that most meets your financial needs.
The two main types of IRAs are the traditional IRA and the Roth IRA. While both plans allow a maximum contribution of $4,000 (2006) per year per taxpayer, they differ in several other areas. For those over the age of 50, you are allowed an additional $1,000 contribution per year.
Because this is a retirement account with preferential tax treatment the IRS will require you to keep the money invested until you reach the age of 59 1/2. Early withdrawals prior to the age of 59 1/2 will be subject to an 10% IRS penalty.
The main benefit of the traditional IRA is that your annual contribution is deductible on your tax return. However, the deductibility of your contribution may be phased out depending on your income. If you have the option to participate in an employer sponsored retirement plan such as 401(k) this may also lower the income threshold for deductibility.
Another benefit of a traditional IRA is that earnings on your account accumulate tax-deferred. However, when money is withdrawn from the plan, it will be taxed at your current tax rate.
Finally, the traditional IRA requires that distributions must begin no later than age 70 1/2. Required minimum distributions (RMD’s)will be calculated based off your age and the amount of money you have invested.
The main benefit of the Roth IRA is that while contributions are made from after-tax dollars and are not deductible on your tax return, all earnings can be withdrawn tax-free.
Like the traditional IRA, the annual allowed contribution of $4,000 gets phased out for individuals with higher incomes. However, for the Roth IRA, your contributions are not affected if you participate in an employer-sponsored retirement plan.
Finally, in contrast to the traditional IRA, there is no distribution requirement and individuals may continue to make contributions after they are 70 1/2 years old.
Which one do I choose?
So based on all the information above, you may be asking “well, which IRA should I choose?” While both plans have their specific pros and cons, there is one general rule that can help you decide.
If you think you are currently making more money and are subject to a higher tax rate than you will be when you retire – then the traditional IRA may be more beneficial because you will be withdrawing your money in the future at a lower tax rate (assuming that tax rates remain the same!)
Likewise, if you are currently in a lower tax bracket then you will be when you take distributions from the plan – then the Roth IRA may be more beneficial because the dollars are taxed while your tax rate is smaller.
One other aspect to keep in mind is that, generally, tax rates increase. Therefore, if you select the Roth IRA you are able to pay taxes today before the IRS raises them.
Another issue that may affect your decision on choosing a Roth or Traditional IRA is control. With a traditional IRA you are in control (of your tax rate) today. With a Roth IRA you are in control (of your tax rate) when you withdrawal the money in retirement.
Tradition IRA = control today
Roth IRA = control in retirement
In my opinion control in retirement is more important than control today because you will be living on a fixed income when you retire. If you needed to work an extra job to pay for increased taxes today you could do so. You may not have that luxury when you are 70 years old!
Whether you decide upon a Roth or Traditional IRA you will be making a wise decision to plan for your future!