How does a traditional IRA differ from a Roth?

Weigh the advantages and disadvantages for each individual retirement account option.

Traditional IRAs and Roth IRAs both offer outstanding retirement and estate planning opportunities to most people who qualify. But there are significant differences between these two options, and you need to carefully compare their characteristics. I typically advise clients to select the Roth IRA option, when all other considerations are equal, because it has significant tax benefits.

Traditional IRA = Tax Deductible

Roth IRA = Tax-free Earnings

One of the primary differences between the two is when the money you invest is taxed. Traditional IRAs are funded with pretax money, so you can save on taxes today because your contributions are deducted from your taxable income for the year. For the IRA to be deductible though, the individual must meet some qualifications. Specifically, neither you nor your spouse can be covered by a qualified retirement plan at work —or your adjusted gross income must be below certain limits. There are also nondeductible IRAs. With a traditional IRA, you will pay taxes on the money you withdraw, and withdrawals must begin at age 70½. While earnings grow tax-free, all withdrawals, including earnings, are taxed. The only exception is for contributions made with after-tax dollars.

Roth IRAs are funded with after-tax money —money on which you have already paid income taxes.

Any person of any age who has compensation can contribute to a Roth IRA, although there are income restrictions. You can invest in a Roth IRA even if you have a retirement plan at work and are maximizing your contributions to it. One of the most attractive features of a Roth IRA is that earnings are never taxed, assuming distributions begin after age 59½ and at least five years have passed since the first day of the tax year for which you first made a Roth contribution or a Roth conversion contribution. Another advantage of a Roth IRA is that withdrawals are not mandatory at any age.

Some other significant differences between Traditional and Roth IRAs

• There are income limits today for eligibility to contribute to a Roth IRA, but almost anyone with earned income can contribute to a Traditional IRA. But the income limit (modified adjusted gross income) of $100,000 for a Roth IRA conversion is scheduled for elimination in 2010, opening this option to far more investors.
• Money you have contributed to a Roth IRA is always available for withdrawal, at any time, for any reason. The withdrawals are tax-free, assuming that distributions begin after age 59½. With some exceptions (such as paying for college, medical expenses, or first-time home ownership) money contributed to a Traditional IRA cannot be withdrawn before age 59½ without a penalty. Even these special withdrawals are subject to income tax.
• With a Roth IRA, you can leave the money invested for as long as you want. With a traditional IRA you must start withdrawing the money at age 70½.
• You can no longer contribute to a Traditional IRA once you reach age 70½. You can contribute to a Roth IRA at any age.
• If you don’t need the money, a Roth IRA can be a tax-advantaged way to pass assets to your heirs.

There are advantages and disadvantages to each option. Several factors, including income level, age and current and anticipated tax bracket, can be used to determine which IRA is right for you.

Roth Conversions

Given the tax benefits of a Roth IRA, there are good reasons to consider converting part of your traditional IRA to a Roth. First, with portfolio values generally down for the past year or so, the tax paid can be much less than when values were high. It makes sense to convert before portfolio values rise again. Second, if you are retired and not yet drawing Social Security, the time would be ideal to convert a portion of your traditional IRA to a Roth. Making the conversion, in either case, does require paying taxes on the converted amount to the extent that it produces taxable income. But, even taking that tax payment into account, the conversion can provide long-term benefits to your family. In 2010 the income ceiling of $100,000 for Roth conversions was eliminated, making a Roth even more desirable.