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Roth IRA versus Traditional IRA: Which is Best for You?

Roth IRA versus Traditional IRA: Which is Best for You?

The term Individual Retirement Account, or IRA for short, is likely familiar to most people. In its basic structure, an IRA is a type of personal retirement savings plan that also provides various tax advantages.

The technical definition of an IRA is a retirement investment account that is established by employed workers (in most cases) who earn either a salary, hourly wage, or self-employment income. IRA accounts can typically be set up through a bank, mutual fund, insurance company, or other type of trustee.

How a Traditional IRA Works

Since its inception in 1974, the Traditional IRA has essentially become a common component for retirement saving. One of an IRA’s greatest features is that it has allowed investors to enjoy the power of tax-deferred growth.

By taking advantage of a Traditional IRA’s tax deferred status, investors do not need to pay taxes immediately on the account’s earnings, allowing growth of the assets in the account to accelerate and compound faster.

Another benefit of owning a Traditional IRA is the tax deductibility of contributions. While there is no limit on how much one can earn in order to be eligible to contribute to a Traditional IRA, there are limits for making a fully or partially tax-deductible contribution.

The deduction for investors making Traditional IRA contributions is phased out for single tax filers and heads of household who are also covered by an employer sponsored retirement plan and have modified adjusted gross income of between $59,000 and $69,000 in 2013. Likewise, for married couples who file their taxes jointly in 2013, the income phase-out range is between $95,000 and $115,000.

What About Roth IRAs?

Roth IRAs were implemented in 1998 as a result of the Taxpayer Relief Act of 1997. The money that is contributed to a Roth IRA is not deductible from ordinary income. However, if an investor meets certain income requirements, all of the earnings within a Roth IRA account will be tax free when withdrawn in the future.

In order to open and contribute to a Roth IRA, an investor must meet certain income guidelines. In 2013, a single person – or an individual who files their taxes as head of household – must earn less than $112,000 in order to make a full Roth IRA contribution. Likewise, the amount that may be contributed to a Roth IRA for those who file taxes jointly begins to phase out if an individual’s annual modified adjusted gross income exceeds $178,000.

In the case of either a Traditional or Roth IRA, there may be a penalty for withdrawing funds prior to reaching the age of 59 1/2. Other than for very specific exceptions, if IRA account money is withdrawn by an investor prior to that time, an IRS penalty of 10% will be levied on the withdrawn amount. And, if such funds are taken from a Traditional IRA, the investor will also be required to pay income taxes on that money.

Other IRA Benefits

In addition to the tax benefits that are received by IRA account holders, there are other advantages that can also make such accounts attractive. For example, IRA accounts are generally given special protections from creditors, making them very useful for asset protection purposes. In addition, when structured correctly, IRA assets can even be passed on to heirs for several generations in the future.

Both Traditional and Roth IRAs are placed in accounts that are held by a “custodian.” The custodian is oftentimes a bank or other financial services company that offers a variety of investments that may be placed inside of the IRA account. These investment vehicles may include individual stocks, bonds, mutual funds, and CDs. Investors are typically able to choose, or “self-direct,” which types of investment vehicles they would like the funds inside of their IRA account to be invested in.

Must You Choose Between the Two Types of IRA Accounts?

There are definite advantages to both Traditional and Roth IRA accounts – and the good news is that in most cases, people don’t necessarily need to choose just one. While one or the other type of IRA account may be better suited to your situation, most investors are eligible to have both types – as long as the maximum amount of annual contribution is not exceeded.

In other words, in 2013, the most you can contribute to your IRA account if you are age 49 or younger is $5,500. Therefore, an investor in this age bracket who has both a Roth and a Traditional IRA may only contribute up to a total of $5,500 – no matter how this amount may be split between the two accounts.

For investors who are age 50 and over, an additional “catch-up” contribution of $1,000 is allowed, giving IRA account holders in this age category an allowable annual maximum contribution of $6,500 for 2013.

In choosing which IRA account will be best for you, it is important to consider all angles, including tax deductibility and deferral, amount of contribution that may be made, and whether or not your income precludes you from participating in an account.