Financial Fellow

   Written by J.P. Wicklein

     In 1998, the U.S. Congress created the Roth IRA.  The Roth IRA differs from the Traditional IRA in several ways - the key difference being its tax structure.  Whereas contributions to a Traditional IRA are often tax deferred, contributions to a Roth IRA are made with earned income that has already been taxed.  Each type of IRA offers its own set of advantages.

(Click here to see a detailed IRA comparison table)

Advantages of a Roth IRA 

·      All withdrawals taken from a Roth IRA after the age of 59 ½ are federal tax free (assuming the funds have been in the account for at least 5 tax years.)

·      The account holder of a Roth IRA can contribute to the account at any age.

·      Roth IRA account holders are never required to withdrawals funds at any age. 

·      Withdrawals of contributions from a Roth IRA are never subject to either taxes or penalties. 

·      The Roth IRA effectively shelters more money in a tax advantaged account than a Traditional IRA.  For 2008, the Roth IRA and Traditional IRA have the same contribution limit of $5,000.  Since a $5,000 contribution to the Traditional IRA is taxed at the time of withdrawal, though, it’s after tax value is less than that of the Roth’s $5,000 after tax value.

·      The income limits to qualify for the Roth IRA’s tax advantage (federal tax free earnings) are higher than the income limits to qualify for a the Traditional IRA’s tax advantage (federal tax deduction on contributions). 

Advantages of a Traditional IRA 

·      The greatest advantage of a Traditional IRA is its tax deduction.  Assuming your income falls below a specified threshold, you can deduct your entire contribution on your federal tax return. 

·      There are no income limits that prohibit your ability to contribute to a Traditional IRA.  Depending upon your income you may not be able to deduct your contributions but, you will still be able to defer taxes on your earnings.          

Which IRA is the best option?

     In most cases I suggest contributing to a Roth IRA over a Traditional IRA (assuming you qualify to contribute to a Roth IRA).  Through a Roth IRA you can shelter more money, are not required to withdraw any of the funds during your lifetime, and can make contributions past the age of 70 ½.  Additionally, in the event of a financial emergency you can withdraw your Roth IRA contributions without paying any taxes, penalties, or be subjected to hardship withdrawal requirements. 

     If you occupy a higher tax bracket during retirement than during your working years (when you were contributing to a Roth IRA) you will pay a lower tax rate on your retirement savings than you would have with a Traditional IRA.  (If, however, you are in a lower tax bracket during retirement a Traditional IRA would provide you with a larger tax savings).  That said, it may be difficult to determine whether you will be in a lower tax bracket during retirement – particularly if your retirement is decades away. 

Future Changes

     Over the last 40 years the U.S. Congress has made changes to tax rates or tax brackets a dozen times.  Given this history of frequent changes, it’s possible that you could pay more or less tax on your income during retirement than you may be planning.  Congress may also change the rules associated with Roth and Traditional IRAs.  If, for example, Congress passed a law to tax Roth IRA distributions it could cause the Traditional IRA to become the more appropriate account to invest your retirement savings in.  In order to ensure that you are making the most informed choice about how to invest your retirement dollars review your tax bracket and any new IRA rules on an annual basis. 

    Whether you opt for a Roth IRA or Traditional IRA, both accounts are capable of providing a tremendous boost to your retirement savings through their tax advantages.  Assuming your income level allows you to contribute to a Roth IRA or, receive a tax deduction through a Traditional IRA, you would be wise to establish an account and contribute to it on a regular basis.