Traditional Vs. Roth IRA: What Are The Differences

On one of my previous article, I’ve talked about the two types of non-employer sponsored retirement plan, which is the Individual Retirement Arrangement also known as IRA: The Traditional IRA and the Roth IRA.

The Roth IRA is fairly new as the plan is only 13 years old (inception is 1998 as a result of the Taxpayers Relief Act of 1997) while the traditional IRA has been around for quite some time. While there was quite a benefit for the taxpayer, the government’s intention is also to try to generate current tax revenues since Roth IRA contributions are made after paying taxes. In addition, the federal can also receive additional revenues through roll-overs from qualified retirement plans or conversions of traditional IRA to a Roth IRA.

Contributions

Current Year Tax Benefit – Roth IRA contributions are made using after-tax dollars, thus, no current year tax benefit. While on a traditional IRA, you may be able to reduce your gross income, thus, reducing your current year taxes as well.

Limit on contribution when you reach 70 1/2 – On a Roth IRA, you can still continue to make contribution even if you are 70 1/2 years old.  On the other hand, 70 1/2 years is the age where a mandatory distribution must be made on a traditional IRA so the government does not want you make any contributions since it would be counter productive.

Phase-out Limitations – When your modified adjusted gross income is more than the IRS limitations, the contributions for both the traditional IRA or Roth IRA may be reduced or phased-out. However, the Roth IRA has a higher phase-out limits than the traditional IRA.

For example, for married joint filers and qualified widower, the IRA contribution is phased out if your modified adjusted gross income (MAGI) is between $169,000 and $179,000 in tax year 2011. On the other hand, the phase-out for traditional IRA is only between $89,000 and $109,000.

Distribution

Tax Consequences on Early Withdrawals:

When you take your money out before you reach the age of 59 1/2 years, it will be considered as an early withdrawal and you may have to pay penalties on that.

  • Roth IRA: Penalty for non-qualified distribution only applies to the earnings and not to the whole amount. This means that if you withdrew your original investment, no taxes or penalties are assessed. However, you won’t get penalized on the early withdrawals of the earnings if you meet certain conditions.
  • Traditional IRA: The early withdrawals of the traditional IRA are included in the taxable income no matter what reason you have. In addition, you have to pay a 10% penalty for the early withdrawals unless it meets one of the exceptions.

At Retirement Age: – When you reach the 59 1/2 years old, the distributions on a Roth IRA are no longer taxed. On the other hand, all distributions are taxed on a traditional IRA.