The difference between a traditional IRA and a Roth IRA comes done to one word – tax-deferred vs. tax-exempt.
Both will allow you to accumulate wealth without paying taxes, but with the traditional IRA you will get a tax bill for the profits and contributions when deductions are made.
The Roth IRA, on the other hand, doesn’t do that. As long as you follow the rules, you never pay taxes on the gains. However, you don’t get a break on your yearly income tax. For this reason, many experts say the Roth may work out to be better.
Let’s say for example, you made $30,000 last year and of that you put $2,000 into a traditional IRA. You would only pay income tax on $28,000. While with a Roth IRA, you would end up paying income tax on the full $30,000 even though $2,000 is in an IRA account.
Both will allow your deposit to grow tax free throughout the years However, when you withdraw the money from a Roth IRA, none of it –not even earnings — will be taxed, provided you meet two rules – the account has been open for at least five tax-years and you are older than age 59 1/2.
With a traditional IRA, when you finally withdraw the money — after age 59 1/2 — you’ll have to pay income tax on whatever earnings the $2,000 have accrued. There is also a 10 percent penalty fee for funds withdrawn before reaching 59 1/2. The good news is there are exemptions such as paying for higher education expenses. Other exemptions include:
- Permanent disability of IRA owner.
- Death of IRA owner.
- Withdrawals are used to pay non-reimbursed medical expenses that exceed 7.5% of adjusted gross income (AGI).
- Withdrawals used to help pay for first-time home purchase.
- Money is used to pay back taxes to the IRS after a levy has been placed against the IRA.
- Withdrawals used to pay medical insurance premium.
The traditional IRA also has penalties for not receiving distributions once you become 70 ½.
You must begin receiving yearly distributions at that age based on your life expectancy, or pay at least a 50 percent penalty on the amount you should have withdrawn. A Roth IRA doesn’t have a mandatory distribution age.
It’s for these reasons most financial experts favor the Roth IRA because in the end, you will be able to draw more money out. It also provides greater flexibility by allowing you, in most cases, to withdraw your principal contributions at any time tax-free, without penalty. First-time homebuyers can also 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.
The downside to a Roth IRA is meeting the qualifications for it, especially if you are single. To qualify a single filer must make up to $95,000. It’s a lot better for couples. They are required to make up to $150,000 jointly.
Basically, if you can qualify for a Roth IRA, go for it, but if not a traditional IRA is a good retirement saving tool also.
Updated IRA Contribution Limits :
2010 Traditional IRA Contribution Limits
The 2010 IRA contribution limits are unchanged. Since 2008, the limit you may contribute to a regular IRA has been $5,000. However, if you will be 50 or older by the end of the year, you can contribute an extra $1,000, for a $6,000 total contribution limit.
These limits apply to both regular and Roth IRAs. Although you may be eligible to contribute to both plans, your combined contribution to both accounts cannot exceed your above limit ($5,000 or $6,000).
2010 Roth IRA Income Limits
There are maximum income limits for Roth IRA contributions. During 2010, married individuals who file jointly can contribute $5,000 ($6,000 if 50 or older) to a Roth IRA only if their modified adjusted gross income (MAGI) is below $167,000. If their MAGI is between $167,000 and $177,000, then they can contribute some amount less than their full limit. If their income exceeds $177,000, they are not eligible to contribute to a Roth IRA for 2010.