This article discusses the pros and cons of the two most popular Individual Retirement Accounts (IRAs), namely Roth and traditional IRA.
Roth and traditional IRA have their share of advantages and disadvantages, and it is always good to examine them before picking one for retirement planning, as it can have pretty big financial effects.
The general trend has shown that the contribution limits of both these accounts are pretty much the same. Perhaps the biggest differentiating factor between them is their tax treatment towards one’s fund. In this debate, we will look at the salient features of both these types of retirement plans, so that you will be able to pick the one which is best suited for your financial needs.
A traditional account works on a simple principle that when the money goes into your retirement account, you have a tax deduction for that amount outright. Say you make $60,000 a year and put in $3,000 as your IRA contribution, that amount will be deducted from your taxable income and you will have to pay tax on $57,000 less any other deductions as applicable. On the other hand, when you withdraw money from the account after celebrating your 59½ birthday, then every withdrawal will be taxed according to the tax rate at the time of withdrawal. So that tax isn’t waived off, it is deferred.
Another important detail about this account is that you need to withdraw all your money from it before you’re 70½ years old. On the other hand, if you withdraw the money before turning 59 ½, you will have to pay a penalty for early withdrawal, which is 10% of the withdrawn amount. Of course, there are certain exceptions to this rule which you could use.
A person with a Roth account retirement plan has to pay tax on the entire amount which he earns, irrespective of how much of it goes into the retirement account. Contributions to this account are not tax deductible. So if the fellow in the previous example makes puts $3,000 of his $60,000 earnings into this account, he still pays tax on $60,000 less any further deductions.
Not happy with it, are you? Well, you will certainly have a surprise on the day you turn 59½, because from that day on, any withdrawal from the Roth account is tax free. Makes sense, doesn’t it?
The important thing to note is that not everyone can use the Roth IRA plan, as one only qualifies for this account if his individual annual income is below $95,000, or his combined income with his spouse is $150,000 or less. Also, it has no mandatory distribution age and funds can be withdrawn any time over the life of the account holder. Its contribution limits are the same as the contribution limit for the traditional IRA.
While there are other seemingly minor differences, the main one is related to the treatment of tax. So, pick one which you think is best suited to your needs!