Investing for your retirement is one of the most important things you can do for your future. And one of the best ways to do that is by investing in an Individual Retirement Account (IRA). There are two main types of IRAs which most people are eligible to contribute to – the Traditional IRA and the Roth IRA. But which is better?
Traditional IRA
Simplified Definition: A Traditional IRA is a tax deferred retirement vehicle. Contributions to a Traditional IRA plan may be tax deductible depending on the taxpayer’s income, tax filing status and other factors. Contributions to Traditional IRAs are made on a pre-tax basis, meaning the money is invested before it is taxed.
The benefit to investing pre-tax money is that it has the potential to lower your current tax bracket, and your money can grow tax free until you withdraw it. Qualified withdrawals are treated as ordinary income and may be subjected to income tax.
Income limits: Everyone is eligible to contribute to a Traditional IRA, but not everyone will get the benefit of a tax deduction. Here is a list of the Traditional IRA deductibility limits.
Withdrawals: Traditional IRA holders are eligible to withdraw from their IRA at age 59 ½, at which point their withdrawals are taxed as ordinary income. There are stiff penalties for early withdrawal (with certain exceptions).
Required Minimum Distributions: Owners of Traditional IRAs are subjected to Required Minimum Distributions, which begin at age 70 ½. This means Traditional IRA holders are required to make a minimum withdrawal every year regardless of whether or not they need the money.
Advantages of a Traditional IRA: There are several advantages for investing in a Traditional IRA, and they primarily deal with taxes. The tax savings at the time of investment may be enough to decrease your taxable income to a lower tax bracket. Many retiree’s income is lower in retirement years, thus they may have a lower tax rate when they withdraw their funds. Depending on your income, you may be able to use a Traditional IRA to lower your tax bracket during your working years, and then withdraw your money in retirement in a low tax bracket.
Disadvantages of a Traditional IRA: The minimum required distribution is a disadvantage because it requires IRA holders to withdraw a certain portion of their funds – whether they want to or not. It is also difficult to determine what your tax rate will be in retirement.
Roth IRA
Simplified Definition: A Roth IRA is a tax exempt retirement vehicle. Contributions to Roth IRAs are not tax deductible when they are made; however, qualified distributions made during retirement years are tax free.
Income limits: A person filing their taxes as single cannot earn over $95,000. Married couples are limited to an annual maximum income level of $150,000.
Withdrawals: The minimum withdrawal age is 59 ½. When the money is withdrawn, none of it is taxed. The principal can also be withdrawn at any time without penalty, however, the earnings must remain in the IRA or they will be subject to taxes and penalties if withdrawn early.
Required Minimum Distributions: There is no minimum distribution for Roth IRA accounts.
Advantages of a Roth IRA: The biggest advantage of a Roth IRA is tax free withdrawals on the principal and all earnings. The other advantage is the absence of minimum withdrawal requirements.
Disadvantages of a Roth IRA: Not everyone qualifies for a Roth IRA because of the income limits.
Which IRA is Better – Traditional or Roth?
Investing with IRAs is a great way to diversify your taxes in retirement years, and as you can see, there are distinct advantages to each type of IRA. If you are like me and have the option of funding a company 401(k) plan or other tax deferred retirement plan, then a Roth IRA may be the way to go. This gives me investments that benefit me now by decreasing my taxable income with my 401(k) contributions, but also investing in a Roth IRA, which will give me tax free withdrawals in retirement. It is very difficult (or impossible) to predict our future tax brackets, so tax diversification is a strong benefit to retirement planning.
I recommend investigating your personal situation and investing in whichever plan you decide is best for you. If you are eligible for both, you also have the option of splitting your investment to take advantage of tax benefits now, and in retirement.
{ 31 comments… read them below or add one }
You covered using a Traditional IRA to lower your current tax bracket which is great, buy you kind of glazed over one of the biggest benefits of a Roth IRA.
If you expect to be in a higher tax bracket in retirement than you are now the Roth IRA is a great investment vehicle. Your current bracket may be reduced by deducting mortgage interest, dependents, child care expenses, etc. If you are saving aggressively in your 20’s and 30’s with kids and a house it is very likely your taxes will be much higher when you are in retirement (15% now vs. 28-35% later). I certainly hope mine are! That doesn’t even factor in potential political and demographics changes that are likely to push tax rates up for everyone in the future.
This is the primary reason why a Roth IRA is best for most people.
Adfecto, you’re correct, I skimmed right over that. The main reason was that I couldn’t word it as well as you just did.
The other reason – there is just no way to tell what anyone’s tax rates will be in retirement. That still doesn’t mean I should exclude the info though. That is the reason Roth IRAs are my preference as well. Thanks for the comment.
Patrick,
I like the idea of tax diversification. If your reader does not have a corporate 401K but has business income, they should consider opening an individual or solo 401K. The individual has the same $15,500 or $20,500 limits (based on age) as a corporate 401(k) plus the ability to add a profit sharing contribution to the 401k. Also, amounts in 401k accounts from previous employers, SEPs, and other before-tax IRAs can be rolled into it. The only catch is that you have to be a solo employee (or the spouse). All of the major brokers and insurance companies have them. If you wish to have the full range of investments, a self-directed solo 401k from certain trust companies may fit the bill (this is what I have.)
Charles, Thanks for the info. This is something I have never dealt with before, but I am sure it might apply to some of my readers. This is the first year I will have some self-employment income, and I have considered opening a SEP IRA, or some other retirement fund to stash away some extra funds. I need to wait to determine how much income I will have after taxes and expenses are paid.
I *just now* (15 minutes ago) opened up a roth SDIRA account. Can you let me in on what benefits and downfalls are of a Self Directed Roth IRA account versus a regular Roth IRA account?
do you invest in a pre-tax 457 or a Roth 1st?
You seem like you know your stuff. Maybe you can help me out. I ended up with a Roth IRA and a Traditional IRA (long story, huge mess…wrote about it on my blog) and I’m wondering if that’s a bad thing. I’m currently unemployed and the Traditional is being funded by the money I had from my previous employer whereas I just opened the Roth and plan on making small contributions even though I’m not working. Is this bad to have both? And what happens when I get a job with a company sponsored 401(k)? I’m lost!
Tiffanie, it’s nothing to worry about. The main difference between the two types of IRAs is when the money is taxed.
Traditional IRAs are funded before the money is taxed from your paycheck and they are taxed when you withdraw funds.
Roth IRAs are funded with money that has already been taxed from your paycheck and withdrawals are tax free.
You can have both types of IRAs, but you can only contribute a combined $5,000 into both accounts per year (at least for 2008 max level; I think the limit increases next year).
A 401(k) is an entirely different investment plan and is not affected by your IRAs, so you can have both.
The taxing of IRA withdrawals,401k withdrawals is absolutely and utterly unfair during times of national emergency. I was totally wiped out after Hurricane Katria and now i find myself with a heavy tax burden. There were no alternatives and the last place to keep myself above water was to take MY OWN MONEY and use it. The new Obama administration should look at reforming this tax law. I shutter to think of the thousands of people using THEIR OWN MONEY(IRA, 401K’s)
during this economic meltdown to keep themselves in their homes with food on the table, and then being kicked in the teeth my the IRS. Reform is needed NOW!
Hello Tom: I’m sorry to hear about your experiences with Hurricane Katrina a few years back and the difficulties you currently face. I understand your frustration, and while the 401k money and IRA money is yours, if is a Traditional version, it has never been taxed. People should be required to pay taxes on their income during times of crisis as well as good times. The government simply cannot afford to run without taking in taxes.
As for changing this, I think it may make sense to remove the early withdrawal penalty, but not remove the taxes which had never been paid.
Patrick: My ponit is simple;this round of foreclosures and human and family misery will be exasperated at the absolute worst time for everyone. Its tantamount to having Bank of America, AIG, and all the other corporate enities recieving tax payers money (not theirs as our Ira and 401K are) and being kicked in the teeth with a huge tax liablity. Would love to see the Congressional Budget Office’s numbers on how much actual revenue the treasury would be losing. I am sure the general economy could use the $$$ alot better than the US treasury. Remember the congress will be considering a stimulus package of 800B to 1 trillion dollars to get our economy going again. Probably talking about a drop in the bucket.
I enjoyed your article. As to your reply to Tiffanie on contribution limits for 2008 & 2009, it’s $5,000 each year. I don’t know about 2010.
On another topic, just a note on your word usage:
“The principle can also be withdrawn”
In dealing with money, you’re talking principal, not principle.
El: Thanks for adding to the conversation, and pointing out my typo. It’s fixed now.
Can I convert my standard IRA to a Roth IRA before 4-15-09, and use my unused 2008 tax decuctions to pay for taxes due on the conversion?
Also, where is the easiest/best place to do the conversion?
thanks, george
George: To be honest, I am not sure if you can or not. I recommend speaking with a CPA or financial planner for more information on this question. I would hate to ster you in the wrong direction.
Patrick, quick question. If I am withdrawing from my 401K employer plan and moving to a traditional IRA and that process takes about 10 days, but taxpreparer said i can claim the $5000 now on my 2008 Taxes, what if that money does not get to me by 4/15/09 from my employer plan. Do i think have to refile an amended tax return and remove it from 2008 or will it be okay as long as the process was started before 4/15/09?
Anita: I’m sorry, I’m not qualified to answer that question. I recommend working with a CPA or other qualified tax professional. Best of luck!
Currently unemployed (laid off) I have a 401 k , my question is at the age of 60 should i consider rolling it over to an IRA? Traditional or Roth?
Thanks.
I’m seperating from the Army and I was wondering if TSP can be rolled over directly to roth IRA since one’s pre and other’s post-tax.
Hojin, You can roll it into a Roth IRA, but you will first have to roll it into a Traditional IRA, then do a Roth IRA conversion. That will involve a little paperwork and paying taxes on the amount of money you roll into a Roth IRA. If you decide to go this route, I recommend having the financial institution assist you with the paperwork (most will do the paperwork for free).
Great info – I have a couple other questions…..here’s some background.
I’m currently participating in (and maxing out my contributions in $$) into my existing employers 401k. I have a ROTH IRA open and want to continue to contribute there, and I have an OLD 401K, still in an ex-employers plan.
What to do with the OLD 401k? Should I roll it into a traditonal IRA or my current employers plan? Advantages/Disadvantages? If this plan contains a high percentage of that companies stock (which has decreased significantly), should I wait until it comes back a bit (it’s showing signs) before rolling it over?
For my ROTH IRA, I am approaching the cutoff limit based on me and my spouses combined salaries. I understand that you use an adjusted gross income to make that calcualtion – so is that basically our nets combined, minus what we contribute (pre-tax) into our 401k’s (and any other allowable deductions)? If I OVER contribute, what happens?
Mike
Mike, This should help you with your decision on your old 401k: Deciding What to Do With Your 401(k ) When You Change Jobs.
Regarding over contributing to a Roth – There may be penalties involved if you contribute too much money, so I would consult an accountant or financial planner for more information on that one. Remember, you have until April 15 of the following year to contribute, so in the mean time, you may consider saving the amount you would normally contribute to a Roth in a high yield savings account. That way you are earning interest and can invest the full amount if you are eligible.
I am married but have filed and will file next year as married filing separately. I do not earn more than 95,000 but together with my husband we would be over the 150,000. Can I still open a Roth IRA under my name?
I have one IRA account and another Roth IRA (with minimum amounts). I would like to consolidate them all into a Roth IRA in the same bank. Is this possible? If so, I would just go to the bank and ask them to do so?
Thank you
I’m not sure about the income situation when you file separately. But you should be able to consolidate your IRA accounts. Your bank should give you a simple form to fill out that will allow them to transfer your old IRAs into one account. You should be able to transfer the funds directly from one IRA to another, but if one of your old IRA accounts sends you a check when you close your account you will need to deposit it into an IRA immediately to avoid early withdrawal penalties.
i have to open a sep ira any advise to witch bank to go to and what to invest in thanks
Paul, Here is a recent article about Where to Open a Roth IRA Account. Not all of these companies offer a SEP IRA, but I believe Vanguard and Fidelity offer self-employed retirement plans, including SEP IRAs. I’m sorry, but can’t offer advice on which funds or investments to go with. Best of luck!
Hey Hey lots of good qeustions here. I will be jumpin in now and then. I have some knowledge on IRAs, 401ks, and some on prospectuses, mutual funds. To Tiffanie…..you can convert IRAs back and forth but there are some implications. I have to pull out my notes on the conversions. I remember one way was better than the other. You can also call any investment firm and they will tell you which is allowed and the adv/disadvantages plus you get the benefit of learning the invesment jargon, lol. Tip of the day/month or, cause I feel tippy!!!!……When rolling over a 401K (due to loss of job…etc) ALWAYS!! transfer those assest to the new institution/firm. NEVER have the check sent to you…trust me you will have more paperwork and headaches to deal with depending on which institution/firm and which idiot in the cubicle you get!!!
When I went to college we were told that the Roth IRA was the way to invest for college. My son is ten years old and I’d like to start a “college fund” now for him. Will his money be tied up until he’s 59 1/2 or is there even a penalty for early withdrawal?
Tiffany, there are better options for investing for college, such as a 529 College Savings Plan, or a Coverdell Educational Savings Account (ESA). You can compare the two plans here: 529 College Savings Plan vs. Coverdell ESA.
One of the best 529 plans is the College Advantage 529 Plan, which anyone can open, not just OH residents. There is also a bonus for new accounts, which you can read about here: Free Money – Ohio College Advantage 529 Plan.
I am not quite 59 1/2, and plan to retire at 62 or 63. I am trying to determine if my understanding is correct and which IRA I should choose. Am I correct that you have to leave your money in a Roth Ira for five years (from contribution) to be able to withdraw it (even partially) without penalty? If so, I don’t necessarily want that one. If I decide to go with a traditional IRA, I believe an earlier blogg said the benefit is that you would contribute tax free now, but how does that work…does your employer somehow get involved, or does the tax benefit come off at the time you calculate your taxes for April 15th…sorry, so uneducated on this…(I really hope the later, don’t want employer knowledge of what/how much I want to add to an IRA) as employer contributes to a (non-employee contributed) retirement plan. (Also, am I correct in thinking a traditional IRA, if you calculate the tax savings at the time you prepare your tax return, it has nothing to do with whether you itemize or not, right???). Thanks for educating me on these issues…
No one evers mention risk with any of these investments. Maybe it was mentioned yet I didn’t see it.
I have 3 401k,s a mutual fund, (had a variable annuity) and owned stocks. I lost about 75% of all assets that were in any risk with the economic meltdown. Fortunately I keep about 70% of all my investments in zero risk accounts (i.e. CD’s and high yield money market accounts). Sure CD’s and such only offer 6% at best during good economy, yet I can’t tell you how many people I know had everything in 401k’s, IRA, and other “Retirement” accoutns only to lose nearly all of their savings when they needed it most (close to their retirements). Now they all either have to go back to work, work longer, or pray the economy has some significant upswing to they can recoup some of their serious loses.
I’d recommend to young people to put a majority of thier savings into zero risk CD’s and traditional savings accounts that offer decent rates of return. Slow and steady savings beginning in your twenties w/ little risk will guarantee you money during retirment that won’t be taxes when you take it out.
Just my 2 cents. You’ve got to ask your self, if you are you saving for retirement then your sure to get there if you live below your means and put money away every year for 30 or more years. 401ks, IRAs, mutual funds, etc .. they aren’t a guarantee now matter how much money you throw into them, -yet your savings account is!