Traditional ira vs. Roth ira which is Better By Joshua Kennon, About com Guide Question

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Traditional IRA vs. Roth IRA - Which is Better

By Joshua Kennon, Guide

Question: Traditional IRA vs. Roth IRA - Which is Better

Answer: Deciding whether to open a Roth IRA or Traditional IRA is a major decision with potentially large financial consequences. Both forms of the IRA are great ways to save for retirement, although each offers different advantages.

Traditional IRA Profile

  • Tax deductible contributions (depending on income level)

  • Withdraws begin at age 59 1/2 and are mandatory by 70 1/2.

  • Taxes are paid on earnings when withdrawn from the IRA

  • Funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.)

  • Available to everyone; no income restrictions

  • All funds withdrawn (including principal contributions) before 59 1/2 are subject to a 10% penalty (subject to exception).

Roth IRA Profile

  • Contributions are not tax deductible

  • No Mandatory Distribution Age

  • All earnings and principal are 100% tax free if rules and regulations are followed

  • Funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.)

  • Available only to single-filers making up to $95,000 or married couples making a combined maximum of $150,000 annually.

  • Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).

Tax Deferred vs. Tax Free

The biggest difference between the Traditional and Roth IRA is the way the U.S. Government treats the taxes. If you earn $50,000 a year and put $2,000 in a traditional IRA, you will be able to deduct the contribution from your income taxes (meaning you will only have to pay tax on $48,000 in income to the IRS). At 59 1/2, you may begin withdrawing funds but will be forced to pay taxes on all of the capital gains, interest, dividends, etc., that were earned over the past years.

On the other hand, if you put the same $2,000 in a Roth IRA, you would not receive the income tax deduction. If you needed the money in the account, you could withdraw the principal at any time (although you will pay penalties if you withdraw any of the earnings your money has made). When you reached retirement age, you would be able to withdraw all of the money 100% tax free. The Roth IRA is going to make more sense in most situations. Unfortunately, not everyone qualifies for a Roth. A person filing their taxes as single can not make over $95,000. Married couples are better off, with a maximum income of $150,000 yearly.

Is there any way to avoid the 10% early withdrawal penalty on my IRA?

Yes! There are ways to avoid paying early withdrawal fees. You can read about the eight exemptions to IRA early withdrawal penalties in another section of the Beginner's Corner. (This article is part of this reading . You can find it on pages 3-4).

Where can I open an IRA?

IRA's of both types can be opened through a bank or brokerage house. If you are interested in holding stocks or bonds in your IRA, it may be wiser to open an account with your broker. It should require no more than a few minutes' visit to the local branch office, or a trip to their website.

How much money do I need to open an IRA?

Minimum opening fees differ by institution, but are dramatically less than other types of investment accounts.

How much can I contribute to my IRA each year?

You can see a chart of allowable contributions year-by-year in the IRA Subject Menu. (this chart is included in this reading beginning on page 5).

Eight Ways to Avoid the 10% Early Withdrawal Fee on Your IRA

By Joshua Kennon, Guide

Many IRA owners are aware they can be hit hard with penalty fees if they withdraw money early. Fortunately, there are ways to avoid these fees if an emergency or other qualifying situation arises. Before we begin, let me say that even with these allowances, you should make every effort to avoid taking money out of your retirement accounts early, especially if you are young. By withdrawing money, you are losing decades of tax-free compounding which can cost you hundreds of thousands of dollars by the time you retire.

1. Permanent disability of IRA owner

Money can be withdrawn without penalty in the event the IRA holder becomes permanently disabled.

2. Death of IRA owner

It's small consolation, but if you kick-the-bucket before you're 59 1/2 years old, your estate won't be hit with the 10% early withdrawal fee.

3. Withdrawals are used to pay non-reimbursed medical expenses

In the event of serious illness or injury that requires prolonged or expensive medical treatment, Uncle Sam will waive the early withdrawal fee on the condition that the expenses are in excess of 7.5% of your adjusted gross income.

4. Withdrawals used to help pay for first-time home purchase

Despite a lifetime limit of $10,000, this exemption can make it much easier for an IRA owner to buy a house.

5. Higher education costs

College can be expensive. Thankfully, certain higher education costs for you, your spouse, children or grandchildren can be withdrawn penalty-free. You may still owe federal income tax, however. For more information, read the Internal Revenue Service article Notice 97-60 Using IRA Withdrawals To Pay Higher Education Expenses.

6. Money is used to pay back taxes to the IRS after a levy has been placed against the IRA

This is not the kind of exemption for which you want to qualify, but it may save you money if you find yourself in an uncomfortable position with the IRS.

7. Withdrawals used to pay medical insurance premiums

Out of a job? The rest of the world may be topsy-turvy, but rest assured, you won't be penalized for using retirement money to pay your medical insurance as long as you have been on unemployment for longer than twelve weeks.

8. Made on or after the day the IRA owner turns 59 1/2

Once you have reached the qualifying age of 59 1/2, you can make penalty-free regular withdrawals upon which to live.

A Caveat

There is one catch to these qualifying exemptions; the holder of an IRA is subject to a five year waiting period (measured in tax, not calendar, years). An investor could not, for example, deposit $3,000 in their IRA this year and withdrawal it next year penalty-free even if it would otherwise qualify as an exemption.

Traditional IRA and Roth IRA Contribution Limits

By Joshua Kennon, Guide

Regardless of the type of IRA you choose, the Federal government imposes annual contribution limits. The chart below shows the maximum dollar amount individuals are allowed to deposit into their IRA each year. After 2010, the contribution limit will raise in increments of $500 depending upon the level of inflation.

Deposits into your IRA do not have to be made at the same time. (For example: In the year 2010, a 35 year old woman could deposit $416.67 into her IRA each month. At the end of the year, it would add up to the maximum $5,000.)

Due to the tax advantages of investing through an IRA, it is normally best to try and make the maximum annual contribution. The use-it-or-lose-it nature of contributions makes this all the more important (e.g., If you deposit $3,000 in 2009, you can't deposit $7,000 in 2010 [the $5,000 + the $2,000 you didn't deposit the prior year]. You cannot contribute more than the total allowable amount during any fiscal year.)

For more information, read our Guide to Retirement Account Contribution Limits. You can also visit our special, 101 Things Every New Investor Should Know About Stocks.

IRA Contribution Limits


























Indexed to Inflation

Indexed to Inflation


Indexed to Inflation

Indexed to Inflation

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