In the United States, there are a number of tax-friendly accounts available for income earners with intentions of saving for the long haul. Two of the more attractive options, for those without corporate benefit plans, are the Traditional Individual Retirement Account (IRA) and the Roth IRA (named for the late Delaware Senator William Roth). The Traditional IRA historically has been the most commonly used retirement account. However, the Roth IRA, which was introduced in 1997, is becoming an increasingly popular option.
The most important difference between a Traditional and a Roth IRA, in a nutshell, is the tax structure of each account. A Traditional IRA uses pre-tax income to the accountholder's benefit, while a Roth uses post-tax dollars that are exempt from future tax obligations. Both can provide advantages to the investor, depending on the individual's current and forecasted financial situations.
With a Traditional IRA, the yearly portion of income placed into the IRA is deducted from the person's total annual income. This lowers the individual's total taxable income, and, in turn, reduces his or her taxes for the calendar year for which money was deposited in the IRA. (Contributions for a given year can be made until April 15th of the following year for both of these IRAs.) The expectation is that the money in the account will grow until it is withdrawn after the age of 591/2 (any money withdrawn before that age will, under most circumstances, be hit with a 10% early withdrawal penalty). There are no tax implications while the money is in the account, so dividends and capital gains can be reinvested without impact on the account owner's taxes. As this money is withdrawn, however, it is considered income and is taxed as such at the account owner's tax rate at the time of withdrawal.
A Roth IRA, on the other hand, is funded with after-tax dollars. In other words, the account holder is using money on which he or she has already given Uncle Sam his dues. Like a Traditional IRA, the money in a Roth grows tax-free until it is withdrawn, presumably in retirement. This, however, is where two big differences arise. First, any money a person puts into a Roth (the principal) can be withdrawn for any reason at any time without consequence. Any money withdrawn before 59 1/2 that is above what was deposited in the account would be subject to a 10% penalty (effectively the capital appreciation on the principal). After 59 1/2, any money in the account can be withdrawn without penalty and without the need to pay taxes on the withdrawals-which is the second big difference.
Restrictions (There Are Quite A Few)
There are plenty of limitations to consider when deciding which account to open, and many more than can be discussed here. Most important, any individual can only contribute $5,500 to IRAs per year ($6,500 if you are age 50 or older). A person can have both Traditional and Roth IRAs, however, the total contribution must not exceed the limit in any given year.
Moreover, a Roth IRA for 2014 filers is only applicable to people with an annual income of less than $114,000 with limitations up to $129,000 for a single person or less than $181,000 and with limitations up to $191,000 for those filing as a married couple. As noted above, funds withdrawn prior to 59 1/2 may be subject to a 10% penalty fee. In addition, with a Traditional IRA, distributions from the account must be taken after a certain age. However, a Roth is not subject to this requirement.
Note, too, that those with corporate benefit plans may, in some instances, be disqualified from funding both Traditional and Roth IRAs. That said, if you already own one or the other (or both), there is no requirement that it be liquidated.
Which is Better (It Depends)
Although there are many more legal nuances to these accounts that may require the professional guidance of a tax professional, the above basics are enough to start a discussion of which account may be more appropriate for a given circumstance.
For example, someone who expects income tax rates to be higher when he/she reaches retirement age would clearly be better off investing in a Roth, as withdrawals would avoid taxation. That said, someone who expects to be in a lower tax bracket might prefer to avoid taxes now by funding a Traditional IRA, choosing to pay taxes later at a presumably lower rate.
Those with ample funds for retirement through other means, a pension for example, might choose a Roth. This is because they only have to withdraw money from a Roth if they want to, not because the government tells them they must because of required distributions (which affect Traditional IRA owners). This can also be beneficial for estate planning purposes, if one would like to leave an IRA to an heir.
Those who are self employed might find a Roth more compelling because they can withdraw their principal from a Roth without penalty. This would be a helpful option if his or her business were to falter or if income-stream volatility were an issue (a consultant might have such a volatile income stream).
Over the long term, most will benefit from owning some kind of IRA. The choice between the two depends on an individual's financial situation and outlook and is best decided with the help of a tax professional. That said, not funding an IRA is a bigger mistake than picking the less-advantageous kind.