Understanding the Difference Between a Traditional and Roth IRA

By Ted Rollins , last updated September 14, 2011

The term IRA refers to retirement plan accounts that give workers tax incentives to plan for their retirements throughout their careers and typically comes in two varieties: a Traditional IRA and a Roth IRA . The Employee Retirement Income Security Act of 1974 introduced the IRA, and it has become one of the most commonly used savings methods in the United States. In what follows, you'll learn about the differences between Traditional IRAs and Roth IRAs.

The Traditional IRA was first offered in 1986 as part of the Tax Reform Act, while the Roth IRA was only introduced in 1997. In recent years, the Roth IRA has become more popular than the Traditional IRA, although the Traditional IRA is still a better option for some. The Roth IRA has a few significant advantages over the Traditional IRA. The biggest advantage of the Roth IRA is that contributions to the fund can be made tax free at any time. Rollover converted contributions that are made to the fund can also be withdrawn without taxes or penalties after the contributions have "seasoned," which generally means that they've been held for over five years and if the policy holder is over 59 1/2. This differs greatly from the Traditional IRA, where any withdrawals made are taxed as what's called Ordinary Income, which has a high tax rate. What's more, traditional IRAs typically tax you for any withdrawal made before 59 1/2. Money that's placed in a Roth IRA after being converted from a Traditional IRA can be withdrawn without penalty too, assuming it's also been seasoned. If you're a first time home buyer, you can also withdraw up to $10,000 tax free in addition to any other withdrawals. If a member of a couple passes away, his or her spouse can take over the Roth IRA or combine it with an existing IRA without taking any penalty. Lastly, Roth IRAs generally have a higher contribution limit than Traditional IRAs pre-tax.

The biggest advantage of Traditional IRAs over Roth IRAs is that the former is usually tax deductible. This leads to a huge difference, and may dictate which type of fund you want to buy into. With a Traditional IRA, you get the tax savings in the beginning, but with a Roth IRA you effectively get the tax bonus when you withdraw. What's more, with Traditional IRAs employer contributions are also tax deductible without income limits. Traditional IRAs have higher income limits than Roth IRAs, and most Traditional IRAs don't have any income limit at all. Another important difference is the effect on one's AGI or adjusted gross income. With a Roth IRA, your AGI is not reduced when you make a contribution, but it is with a Traditional IRA. By reducing your AGI, you decrease your overall tax burden, which can be a huge advantage to some workers. Before making a decision about what type of plan is best for your circumstances, make sure to consult a trusted financial advisor.

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