All About IRAs
Traditional vs. Roth
Of course it's true that there are 11 types, but the two we hear the most about are the traditional IRA and the Roth IRA. What, in a nutshell, is the difference? Well, here's the nutshell.
The tax breaks for a traditional IRA are of the "this is tax-deductible" kind. That means that, depending on previously discussed factors, the money you deposit in your IRA isn't taxed. And regardless, whatever earnings you have on your contributions won't be taxed until you withdraw that money many years later.
For example, let's say you made $30,000 during the year, and you put $2,000 of it into an IRA. You would pay income tax on only $28,000. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate.
If you withdraw the funds before age 59 1/2, then in most cases you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- but if the funds are used to pay for "qualified higher education expenses" or for one of the other eight exceptions to the 10% early withdrawal penalty, then the penalty will be waived.
Remember that you can put just about anything you want in an IRA account. Under the onslaught of marketing from banks, you may have come to the conclusion that an IRA is somehow connected to a CD (certificate of deposit). This is because that is what most banks sell.
But be advised, Fool: You're not limited to what the banks offer. If your outlook is Foolish, and you'd like to take control of your investing future, and you think you can develop some market-beating returns, then by all means, plunge ahead, with IRA and tax savings happily in hand!
The Roth IRA
The tax breaks for a Roth IRA are different. Unlike a contribution to a traditional IRA, a Roth IRA contribution is never deductible. Taking the above example, you'd still be taxed on $30,000 even though you had put the same $2,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it -- and that includes the earnings -- will be taxed, assuming that the Roth IRA has been open for at least five tax-years and you are older than age 59 1/2. That's right -- you get off scot-free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as it's been in there for at least five years.
In other words, the Roth offers tax-exempt rather than simply tax-deferred savings. One word makes a big difference. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions if those were deducted when made). The Roth doesn't. As long as you follow the rules, you never pay taxes on your gains. So paying the piper now before contributing to the Roth may work out to be better for you than paying him later on your investment profits.
The Roth makes particular sense for people otherwise limited to making non-deductible contributions to a regular IRA. And the Roth is fully available to single filers making up to $95,000 and couples making up to $150,000. It also allows you great flexibility by allowing you, in many 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. There are also some breaks for education spending, though an Education IRA may be a better vehicle for education savings. Barring these exceptions, though, profits withdrawn before retirement age and before the money has been in the Roth for at least five tax-years will be taxed, plus you'll also incur a 10% penalty when those earnings are taken before age 59 1/2.
You can plug in your own numbers to compare the two types of account by using our IRA calculators.
To Convert or Not to Convert
Because the Roth is potentially better than the traditional IRA, it may make sense for you to convert a current traditional IRA into a Roth. To do so, you will have to pay taxes on your old IRA, but there will be no penalty for early withdrawal. Is this a smart thing to do? The answer depends on your income tax rate today versus that in retirement; how you will pay the income tax bill due on the conversion; how long the Roth IRA will remain untouched; and the size of the IRA coupled with your desires for your estate. For a discussion of some of the considerations involved in making such a decision, see "Convert to a Roth IRA."
In general, if you have to use your IRA savings to pay taxes triggered by shifting them to a Roth, then you may be sacrificing too much principal up-front to make the deal worthwhile, unless you have many years to make up for this dip into your savings. You should also note that funds rolled over into a Roth IRA come under greater restrictions for penalty-free and tax-free distributions as compared to normal Roth IRA contributions.
Want to make a quick conversion comparison? Use our handy IRA calulators, to plug in your own numbers and see if conversion is for you.
Now that we've laid out some of the main differences, let's proceed to a more in-depth analysis of the Roth IRA.