Both traditional and Roth IRAs are excellent places to keep your retirement investments. But you must make a choice about whether you want to pay income tax on your retirement savings upfront while you are working or defer income tax until retirement. Here is how to decide which type of retirement account you should use.
Traditional IRA. The traditional IRA was created in 1974 by the Employee Retirement Income Security Act (ERISA). This retirement account, often called the deductible IRA, is a favorite of taxpayers seeking more tax deductions now. You can deduct the amount that you contribute to your traditional IRA on your annual tax return.
Traditional IRAs have annual contribution limits and not everyone can contribute tax-deductible funds to these accounts. Income level and whether or not you have a 401(k) or other retirement account at work affects who can get this retirement savings tax break.
Additionally, once you put your money into a traditional IRA, it should remain there until you retire. Otherwise you will face taxes and early withdrawal penalties. And when you do retire you'll still need to pay taxes on the money when you take distributions. You are required to start taking annual withdrawals after age 70½.
Roth IRA. The Roth IRA didn’t come along until decades later with the passing of the Taxpayer Relief Act of 1997. You can thank Senator William Roth, for whom the Roth IRA is named.
The Roth IRA is for people who don't mind making their retirement contributions with after-tax dollars so that they can pay fewer taxes when they retire. Like the traditional IRA, the Roth IRA rules state that there are limits on the amount you can contribute each year and income limits on your eligibility to participate. But you won't find the employer plan limits, so you can generally use a Roth IRA in conjunction with your employer's retirement plan.
Once you reach retirement age, you can start withdrawing your funds tax-free. Since you make after-tax contributions to Roth accounts, you have a lot more flexibility with regard to taking distributions. Withdrawals are not required in retirement. If you take a distribution before age 59½ you will have to pay income tax and a 10 percent early withdrawal penalty only on the portion of the withdrawal that comes from earnings.
Traditional IRAs give you a tax deduction that lowers your current tax bill, but taxes must eventually be paid on the money in retirement. Roth IRAs offer no upfront tax break, but you free yourself from the obligation to pay taxes on the money and the earnings in the future. You can contribute up to $5,000, or $6,000 if you are age 50 or over, to either or both types of retirement accounts in 2011. The annual limit is spread across all of your IRAs, no matter which tax treatment you choose.
Philip Taylor is the author of 104 Ways to Save Extra Money. Read his popular blog, PT Money: Personal Finance for more insightful money tips, like his recent suggestions for the best online checking accounts.