Two of the most popular and easily recognized forms of retirement accounts include the tradition and Roth IRA. IRAs differ from employer sponsored retirement account such as a 401k or 403b, which can only be opened through a relationship with an employer. An individual retirement account (IRA) can be established by any individual or married couple that meets the eligibility requirements. See IRS Publication 590 for specific details.
There are several similarities between the traditional and Roth IRA, but they are in fact very different options for those looking to save toward their retirement. It is important to recognize what these differences are and how they will impact your savings strategy before you begin contributing to either type of account. Consider the following tips to ensure you are selecting the best account to meet your current and future needs.
Compare Traditional and Roth IRA
Features of the Traditional IRA
Eligibility: There are no income restrictions limiting who can contribute to a traditional IRA. The only eligibility requirement you must pass is age, that being under 70 1/2 at the end of the calendar year in which you make contributions.
Contributions: Contributions must be made from taxable compensation. This means the money that you put into your traditional IRA must be from wages earned, bonuses, commissions or self-employment. You may not use investment gains, royalties, rent payments or other non taxed compensation to contribute to a traditional IRA. (Some service members maybe able to contribute to a traditional IRA with non-taxed combat pay under the HERO Act).
Taxes: Contributions to a traditional IRA are made with pre-tax dollars. When the time comes to file your income tax return, this will reduce your taxable income which offers immediate tax advantages. This allows for tax-deferred savings, however it is important to note that when you take distributions from the traditional IRA you will be subject to taxation.
Distribution: To avoid early withdrawal penalties, distributions must be made from a traditional IRA after the account owner has reached age 59 1/2. The traditional IRA also has a mandatory minimum distribution age of 70 1/2. This means the account holder must begin taking minimum distributions at age 70 1/2 or risk losing up to half of the minimum distribution to the IRS as a penalty.
More information from the IRS: traditional IRA.
Features of the Roth IRA
Eligibility: Before considering a Roth IRA understand that there are income requirements that must be met before you can establish and contribute to this type of account.
Contributions: Contribution rules for the Roth IRA are the same as the traditional IRA. They must be made from taxable compensation as listed above.
Taxes: What many consider the biggest advantage of the Roth IRA is how it is taxed. Basically you pay tax on your contributions at the time of contribution, therefore you are free and clear of taxes on qualified distributions from this type of account. This can be a very attractive feature for those who do not want to worry about paying taxes at a later time. It also makes the Roth IRA a bit more flexible than the traditional IRA in terms of withdrawals.
Distribution: Since you have already paid taxes on contributions to the Roth IRA, they can be withdrawn at any time without taxation. Earnings from the account cannot be taken prior to the account being open for five tax years and the account holder reaching age 59 1/2 without penalty. Money can remain in the account for the remainder of your life, due to the fact that there are no age limits when minimum distributions must be made.
More information from the IRS: Roth IRA.