Roth IRA vs. Traditional IRA

Difference Between Roth IRA and Traditional IRA

If you wish to start a retirement plan then you must find out all about different planning tools and how these tools can help you in saving money for your retirement. Out of the 11 planning tools IRA and Roth IRA are the two most popular planning tools.

The traditional IRA or the Individual Retirement arrangement is a plan which helps you in saving money for your retirement while you are still working and you get tax benefits as per the US law on these savings. Roth IRA is named after the late senator of Delaware William Roth, who was the chief legislative sponsor of this plan. This is a special plan in which your savings are not taxed if you meet certain conditions.

Facts about IRA:

  • The money you save through IRA is not taxed until you make withdrawals before the age of 50.5. If you make withdrawals then you not only pay the taxes but a penalty of 10% on all the earnings accrued by you. If you withdraw for certain expenses which are exempted then you get a waiver on this penalty.
  • For IRA, all the maintenance payments and taxable allowances are counted as compensation while earnings from dividends, rent from a property, interest on other savings, pension, etc is not counted as compensation.
  • Even if you have other retirement plans, you can opt for IRA but if your employer covers you under a retirement plan then you may not be able to deduce all the contributions.
  • It can be set up very easily through a financial institution like a mutual fund or Life Insurance Company or even a bank. You can also do it through your stock broker.

Facts about Roth IRA:

  • You can leave the amount in Roth IRA for your lifetime.
  • Roth IRA can be Individual Retirement account or Individual Retirement Annuity and in both the cases the applicable rules are similar to the traditional IRA apart from some exceptions.
  • This gives you more flexibility. This is why you can easily withdraw money without paying any penalty if your money has been in Roth IRA for 5 years. You can do this for buying a house or for spending on education.

Individual Retirement Account is an account which is set up In US for your benefit and it is done through a written document. This account must meet some of the important criteria. These criteria are:

  1. As this is a custodian account, you need an IRS approved custodian for your account. This can include credit union insured by Federal government, a bank or even a loan association.
  2. This custodian is not allowed to accept any contribution that exceeds the deductible amount for a particular year. An exception to this will be employer contribution made to simplified employee pension and the rollover contributions.
  3. All the contributions must be made in cash except the rollover contributions and all these amounts should be non-forfeitable.
  4. You cannot buy a life insurance policy from the money in this account and this money can only be combined with common investment fund or common trust fund. You cannot combine it with any other asset of yours.
  5. You should start getting distributions from April 1 of the year after you turn 70.5.

Individual Retirement Annuity can be easily set up by buying an endowment contract or a retirement annuity from a life insurance company. This is issued on the name of the owner or along with the names the people who are to get the benefits after you. This retirement annuity must meet following criteria:

  1. The interest in the contract cannot be rescinded.
  2. The premiums must be flexible so that your compensation can change with your payments. This is applicable to all the contracts issued after Nov 6, 1978.
  3. Your contributions cannot be more than the deductible amount for a financial year and the distributions should start after you are 70.5

To be able to select the best retirement plan out of these two, you must know about these.  Here is a brief comparison between two of them:

  • In case of IRA you contribute money from your income and earn benefits on your taxable income. You get tax credits on the percentage of your income that you contribute to your retirement plan while the savings in case of Roth IRA are non taxable.
  • You do not get exemption from tax when you withdraw money in IRA and if you got tax exemption while contributing towards IRA then your withdrawals are fully taxed. You are not taxed in Roth IRA except in the case of non-qualified distributions. Non-qualified distribution refers to withdrawals which are made earlier than 5 years after you set up Roth IRA.  A qualified distribution is the withdrawal that you make at least 5 years after you set up Roth IRA and in this case your age must be 59.5 or if you are withdrawn to buy your house or if the withdrawals are made if the person is deceased.
  • If your age is less than 70.5 and your earning include taxable elements like salary, bonus, wages or if you are self employed then you can set up IRA at the end of a financial year while you can set up Roth IRA once you have crossed this age.
  • You can set up IRA with your spouse if both of you get are earning and below the age of 70.5 but only one of will get the tax compensation whereas in case of IRA.

Well you can contribute to both of these retirement plans provided your contributions to these plans does not exceed your income.