UPDATE: Traditional IRA vs Roth IRA – What’s the Difference?

By Bels

Last week I sent out a message asking my Facebook friends for financial topics for the STACKS Mag blog. I figure this will be a good way to find out exactly what people want to read about. So a close friend of mine from high school sent in a question. He wanted to know what was the difference between an IRA versus a Roth IRA. Hopefully the information I’m about to let my friend in on helps everyone decide what’s the best investing strategy for them.

What does IRA stand for? An IRA is a Individual Retirement Arrangement. It provides a tax-free or tax -deferred way of saving for your retirement. Although there are various kinds of IRA’s , depending on your financial goals or situation, the most commonly used are Roth’s and Traditional.

To break it down, here’s how each one differ:

Traditional IRA

• depending on your income level, the contributions you make through your job paycheck are tax deductible
• by the age of 59 1/2, withdraws from your account can be made; and are mandatory by 70 1/2.
• taxes are paid on earnings when withdrawn from the IRA
• funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.)
• available to everyone; no income restrictions
• all funds withdrawn (including principal contributions) before 59 1/2 are subject to a 10% penalty (subject to exception).

Roth IRA Profile

• paycheck or deposit contributions are not tax deductible
• no mandatory distribution age
• all earnings and principal are 100% tax free if rules and regulations are followed
• funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.)
• available only to single-filers making up to $95,000 or married couples making a combined maximum of $166,000 annually.
• principal contributions can be withdrawn any time without penalty (subject to some minimal conditions)

To sum it up, the major difference is how the IRS treats the taxes. For instance, if you earn $50,000 a year and put $2000 of that in a Traditional IRA, you will be able to deduct that $2000 from your income taxes (only having to pay tax on $48,000). When you turn 59 1/2 years old, you can begin withdrawing funds. But note, that you will have to pay taxes on all interest, capital gains, dividends, etc that you earned on your contributions over the years.

On the flipside, if you put the same $2,000 in a Roth IRA, you would not receive the income tax deduction. If you needed the money in the account, you could withdraw the principal at any time (although you will pay penalties if you withdraw any of the earnings your money has made). When you reached retirement age, you would be able to withdraw all of the money 100% tax free. The Roth IRA makes more sense in most situations. but unfortunately, not everyone qualifies for a Roth. A person filing their taxes as single can not make over $95,000. Married couples are better off, with a maximum income of $150,000 yearly.

To open an IRA account, you can visit your local bank or use an investment broker. If you’re already set up with a retirement savings plan with your job, you may want to contact an advisor at the investment company your job uses.

Also as with most things, there are limitations as to how much you can contribute to your IRA in a years time. Since 2008, the maximum amount has been:

How much do you need to open an IRA? Well, it differs from bank to bank. So check with several institutions to find out how much you’ll need in order to open up an IRA.

Thanks Aki for the questions. Hope this helps!

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Update: In 2009, the annual income needed to qualify for a Roth IRA is $166,000 for married couples.

Thanks to our reader, Mr. JB, for catching that!