Roth vs. Traditional IRA – What’s The Difference?

More options are a good thing for saving your money for retirement. The Roth Individual Retirement Account (IRA) is a sibling to the traditional IRA. Some might not be familiar with the important differences between them so we will examine those here.

Traditional IRA

This is the one that has been around the longest and is the most familiar with tax payers. The term that best describes the taxable state of an IRA is “tax deferred.” This means that you can put pre-tax money into an IRA up to a specific amount set by the Internal Revenue Service. The benefit here is that you are not taxed on the contributions that you make to the account as long as you keep the money there until you turn 59 ½ years of age.

However, if you do decide to remove money from the account, you will pay the income taxes on that money along with a 10% penalty. There are certain exemptions though. For example, the money can be withdrawn without penalty if it is used for higher education expenses that are qualified by the IRS.

Roth IRA

The new IRA that has become very popular lately is called the Roth IRA. Instead of taxing you after you withdraw the money at age 59 ½, the Roth IRA contributions are taxed up front (before you deposit the money). The advantage comes in the form of completely tax-free retirement money at age 59 ½ (and a five year minimum on having the account open). This provides a certain peace of mind and makes the money available to use as needed once your retirement years begin.

The one benefit that makes a Roth IRA even better than the traditional IRA: if you follow the rules, you will never get taxed on the gains in your account. This becomes a major factor for those who are investing with their Roth IRA money. The more they make, the more they keep. It is one way that you can legally “cheat” the government out of money. Most financial advisers call that "sheltering."

Also, consider that no one really knows what tax rates will be when they retire, so paying the taxes now makes a lot more sense than paying them later at a yet undetermined amount.

Conversion Process

With the popularity of the Roth IRA many investors want to know how they can convert their traditional IRA over to a Roth. You will have to pay the taxes on your traditional IRA when it is moved to the Roth account, but you will not have to pay the 10% penalty. You should seek the advice of a professional financial planner, however, to make sure that this is a wise move to make with your money.

The decision-making process involves looking at your current tax rate, and considering what it will be at retirement. Then, you also should look at the amount that you will be taxed by pulling your money from the traditional IRA and moving it to the Roth. If you have to use some of the money from the traditional IRA just to pay the taxes, then it might not be a good idea. The other factor is time. The younger you are when you decide to make this move, the better you will be because you will have enough time to make up for the loss in taxes in the conversion process.

Roth IRA’s are in the lead as the best way to save money for retirement if you are self-employed or do not have an employer sponsored 401k plan. Look into one today to see if it is right for you.