What Are the Differences Between a Traditional and Roth IRA

Taxation

Perhaps the biggest difference between a Roth IRA and a Traditional IRA is the way that contributions and earnings are taxed.

Any contributions made to a Roth IRA are made with after-tax dollars. Furthermore, you cannot claim a tax deduction for these contributions. Since you have already paid tax on any money that you have contributed to your Roth IRA, the funds in this account are free to grow tax-free forever.

In theory, these funds have no limit on how large they can grow without having to ever pay a penny in tax again.

On the other hand, contributions to Traditional IRAs are made with pre-tax dollars. Furthermore, these contributions qualify for a tax deduction in the year they are made. Investments in a Traditional IRA grow on a tax deferred basis. No tax is due until you begin making withdrawals. Withdrawals from Traditional IRAs are taxed at the individual’s ordinary tax rate.

Mandatory Withdrawals

Another major difference between these two forms of retirement accounts are the varying IRA withdrawal rules.

When it comes to funds invested into Roth IRAs, there are no mandatory withdrawal rules. An investor is free to leave their money into the account, and allow it to grow tax-free, as long as they want. Investors are even allowed to leave it to their heirs.

Traditional IRAs, however, have a completely different set of guidelines when it comes to taking withdrawals. If you have a Traditional IRA, you must start taking distributions by April 1^st following the year in which you turn 70 ½.

The IRS code specifically outlines how much you are required to take, known as the required minimum distribution, via a complex formula that takes into account your age, life expectancy, and account balance.

Early Withdrawals

Regardless of the type of IRA you ultimately use, your contributions should be earmarked for retirement and not withdrawn before you reach retirement age. In order to ‘encourage’ investors to keep their money invested, the IRS typically assesses a 10% penalty on any withdrawals made before the account holder turns 59 ½ (see exceptions below).

Unlike contributions made to a Traditional IRA, those made to a Roth have already been taxed. As such, these contributions can be made tax-free at any time (the 10% penalty made still apply).

How Can an Investor Avoid Paying the 10% Early Withdrawal Penalty

There are a few circumstances where the IRS will waive the 10% early withdrawal penalty.

• Qualified higher education expenses
• Qualified first home purchase
• Major medical expenses
• Long-term unemployment expenses
• Permanent disability
• Part of a substantially equal periodic payment plan

Income Limits

According the IRS Publication 590, not everyone qualifies to participate in a Roth IRA. If your adjusted gross income exceeds a certain amount, the maximum amount that you can contribute may be reduced, or even eliminated completely.  

Final Thoughts

While it is certainly true that both Traditional and Roth IRAs can be effective tools to save for retirement, it is important to consider your personal circumstances before choosing one over the other.