Difference Between Roth IRA and Traditional IRA

Roth IRA vs Traditional IRA

Retirement planning is an important part in everyone’s life. One cannot simply start a plan overnight without adequate knowledge about the plans available. But first and foremost, one must have the motivation to start a plan. A knowledge on retirement planning tools and their benefits is important to decide on how much to save and the best ways to do so.

There are 11 types of retirement plans, but the two most popular ones are the traditional IRA and the Roth IRA.

An individual retirement arrangement, or IRA, is a personal savings plan under US law, which allows one to set aside money while earning for retirement and offer tax advantages.

Once decided to open an Individual Retirement Arrangement, or IRA, one need to decide the type of IRA suitable for them; whether to open a Roth IRA or Traditional IRA or both as this involves large financial consequences. Here we are trying to give some important facts for decision making by comparing and differentiating both plans.

Traditional IRA 

The original IRA (sometimes called an ordinary or regular IRA) is referred to as a “traditional IRA.”

In traditional IRA, one may be able to deduct some or all of their contributions to IRA from the taxable income and may also be eligible for a tax credit equal to a percentage of contribution. Amounts in IRA, including earnings, generally are not taxed until distributed.

Amounts you withdraw from your IRA are fully or partially taxable in the year you withdraw them. If you made only deductible contribution, that is if you have already got a tax deduction for your IRA participant contribution, then the withdrawals are fully taxable.

You can set up a traditional IRA at any time and make contributions to a traditional IRA if you were under age 70 1/2 at the end of the tax year and you (or your spouse, if you file joint return) received taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self–employment. Taxable alimony (allowances) and separate maintenance payments received by an individual are treated as compensation for IRA purposes.

Compensation does not include earnings and profits from property, such as rental income, interest and dividend income or any amount received as pension or annuity income, or as deferred compensation.

If both you and your spouse have compensation and are under age 70½, each of you can set up an IRA. You cannot both participate in the same IRA. If you file a joint return, only one of you needs to have compensation.

You can have a traditional IRA, even if you are covered by any other retirement plans. However, you may not be able to deduct all of your contributions if you or your spouse is covered by an employer retirement plan.

You can set up an IRA at a bank/ financial institution/ mutual fund/ life insurance company or through your stockbroker.

 The following are two advantages of a traditional IRA:

  • You may be able to deduct some or all of your contributions to it, depending on your circumstances.
  • Generally, amounts in your IRA, including earnings and gains, are not taxed until they are distributed.

Roth IRA

A Roth IRA is a special type of individual retirement plan under US law that is generally not taxed, provided certain conditions are met. The name Roth IRA was given for its chief legislative sponsor, the late Senator William Roth of Delaware.

A Roth IRA differs from traditional IRA in tax breaks; unlike the deductible contribution to a traditional IRA, a Roth IRA contribution is never deductible. Rather Roth IRA offers tax-exempt on withdrawal from the plan during retirement.

Also, all qualified distributions are tax free, but like any other retirement plans, non-qualified distributions from a Roth IRA may be subject to a penalty upon withdrawal.

A qualified distribution is the withdrawal that is taken at least five years after you establish your first Roth IRA and when your age 59.5 or if disabled or using the withdrawal to purchase a first home or deceased (in which case the beneficiary collects).

This is an advantage Roth IRA may have compared to a Traditional IRA.

Contributions can be made to your Roth IRA after you reach age 70½ and you can leave amounts in your Roth IRA as long as you live.

A Roth IRA can be either an Individual Retirement Account or an Individual Retirement Annuity and subjected to the same rules that apply to a traditional IRA, with few exceptions. 

An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets all of the following requirements.

  • The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.
  • The trustee or custodian generally cannot accept contributions of more than the deductible amount for the year. However, rollover contributions and employer contributions to a simplified employee pension (SEP) can be more than this amount.
  • Contributions, except for rollover contributions, must be in cash. See Rollovers , later.
  • You must have a nonforfeitable right to the amount at all times.
  • Money in your account cannot be used to buy a life insurance policy.
  • Assets in your account cannot be combined with other property, except in a common trust fund or common investment fund.
  • You must start receiving distributions by April 1 of the year following the year in which you reach age 70½.

Individual Retirement Annuity

You can set up an individual retirement annuity by purchasing an annuity contract or an endowment contract from a life insurance company.

An individual retirement annuity must be issued in your name as the owner, and either you or your beneficiaries who survive you are the only ones who can receive the benefits or payments.

An individual retirement annuity must meet all the following requirements.

  • Your entire interest in the contract must be non-forfeitable.
  • The contract must provide that you cannot transfer any portion of it to any person other than the issuer.
  • There must be flexible premiums so that if your compensation changes, your payment can also change. This provision applies to contracts issued after November 6, 1978.
  • The contract must provide that contributions cannot be more than the deductible amount for an IRA for the year, and that you must use any refunded premiums to pay for future premiums or to buy more benefits before the end of the calendar year after the year in which you receive the refund.
  • Distributions must begin by April 1 of the year following the year in which you reach age 70½.

To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is set up.

One can contribute to a traditional IRA or Roth IRA or both. But the total contributions to either plan cannot exceed the person’s earned income.

To summarize;

In traditional IRA the tax is deductible, which means the money you deposit in your IRA isn’t taxed until you withdraw that money many years later. In effect, your deposit will grow free of tax through the years and when and only when you finally withdraw the money for your retirement (that is after age 59 1/2), you will be taxed at the ordinary income tax rate.

But if you withdraw the funds before the age 59 1/2, then you’ll have to pay both income tax and a 10% penalty on whatever earnings have accrued. But, if your withdrawals are to pay for accepted exceptional expenses then the 10% early withdrawal penalty will be waived.

Roth IRA contributions are never tax deductible. Rather, Roth IRA offers tax-exempt on withdrawal from the plan during retirement.

Also, Roth IRA allows great flexibility by allowing tax-free qualified distributions without penalty before retirement age. For example, first-time homebuyers can pull out $10,000 in profits penalty free and tax-free if the money has been in the Roth IRA for at least five tax years.  There are also some breaks for education spending.