Traditional and Roth individual retirement accounts, or IRAs, are each an essential retirement savings vehicle. They also share two key similarities: Both are smart ways to grow your money in a tax-efficient way for retirement, and they each enable you to invest as much as $6,500 per year.
However, the similarities end there. As you consider which type of IRA is right for you to open today, the best choice will depend on your current and projected future income tax rates and, possibly, other factors. (And don’t worry: Ultimately, you can have both kinds of IRAs, as well as a 401[k] plan.)
To get you started, here are some of the key differences between a traditional and a Roth IRA. To be sure, there are a number of caveats to each of kind of account, and it’s well worth checking out the Internal Revenue Service website or consulting a tax specialist if you have specific questions.
The basics: With a traditional IRA, you typically get a tax deduction on your contributions. You don’t pay taxes until you withdraw the contributions and earnings in retirement after age 59½, though you’ll owe taxes plus penalties if you withdraw earlier.
Anyone under 70½ with taxable income can invest in a traditional IRA, though deductibility may be limited (see below). If you contribute to an employer plan, you can roll those funds into a traditional IRA when you change employers.
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Contribution limits: The maximum contribution for 2014 is $5,500 for people under age 50 and $6,500 for people 50 and older. Unlike the Roth IRA, income limits don’t apply for traditional IRAs, but if you participate in an employer-sponsored plan (e.g., 401[k], 403[b]) and you make more than $60,000 (single) or $96,000 (married filing jointly), your deduction may be reduced or eliminated. (Check with the IRS for your exact income phase-out levels.)
If you don’t participate in an employer-sponsored plan, you can take the full deduction if your spouse also doesn’t participate in an employer plan, no matter your income.
If you file jointly with a spouse who participates in an employer plan, you get a partial deduction if you make between $181,000 and $191,000 and no deduction if you make more.
If you file separately from a spouse who participates in an employer plan, you get a partial deduction if you make less than $10,000 and no deduction if you make $10,000 or more.
Roth IRAs have been rapidly gaining popularity among Americans over the last several years. Recent statistics from the IRS show that traditional-to-Roth IRA conversions increased by 800 percent over a one-year period, from $6.8 billion in assets in 2009 to $64.8 billion in 2010.
The jump came nearly four years after Congress changed a law that had limited people with a high salary—$100,000 or more at the time—from contributing to a Roth IRA.
So why are people going after Roth IRAs?
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The basics: Unlike with a traditional IRA, contributions to a Roth IRA are not tax-deductible, but in many cases, withdrawals are tax-free. In other words, you pay taxes now so that you don’t have to later. That means they’re especially beneficial for people who think they’re going to be in a higher tax bracket upon retirement.
Tax benefits: Contributions to Roth IRAs are not tax-deductible, but withdrawals of original contributions are tax-free. Additionally, any earnings and funds converted to a Roth from other retirement plans, such as a traditional IRA, are tax-free after the IRS’s five-year aging requirement has been met and you are 59½ or older. If certain conditions are not met, early withdrawals of earnings are typically taxable and subject to a 10 percent penalty.
“Contributions to a Roth IRA are not tax-deductible, but in many cases, withdrawals are tax-free. In other words, you pay taxes now so that you don’t have to later.”
Contribution limits: For a Roth IRA, the deposit limit for 2014 is $5,500 for people under age 50 and $6,500 for people 50 and older. However, with a Roth IRA, contributions are phased out according to income level, ending with an income limit of $129,000 for single filers and an income limit of $191,000 for joint filers.
As with traditional IRAs and tax deductions, you may only qualify for a reduced contribution based on your income level. (See the IRS website for more detail.)
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It’s possible to continue funding your Roth IRA even after you’ve hit the income limit, without breaking the rules. High earners can still access a Roth IRA in what’s known as a backdoor Roth conversion‚ where funds are first placed into a traditional IRA and then converted to a Roth.
Additional benefit: A Roth IRA can also double as your down-payment savings if you’re planning to buy a house—the IRS permits a total of $10,000 to be withdrawn from your Roth IRA toward your first home, without penalties.