Key Differences between Traditional and Roth IRA

Last week I got an email from a reader about the difference between Traditional and Roth IRA. The question is more on the withdraw side than contribution side. After giving a quick answer, I feel I can expand it a little bit with more information on this topic. But tax rules are always complex, so this by no means is complete. Instead, it focuses on the major differences.

First of all, what is Traditional IRA and what is Roth IRA? According to IRS definitions (Publication 590), a Traditional IRA is “any IRA that is not a Roth IRA or a SIMPLE IRA,” and a Roth IRA is “an individual retirement plan that is subject to the rules that apply to a traditional IRA.” Are these definitions clear? Not at all. Therefore, a better way to understand them is by examining the key differences between these two.

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Eligibility

Everyone has earned income can participate in IRA (when the income is greater than the contribution), however

  • Traditional: Only eligible for age under 70.5 with no maximum income limitation;
  • Roth: Only eligible when earned income is less than $114,000 for single, or $166,000 for married filing jointly, with no age limit;

Deductibility

  • Traditional: If you or your spouse is not covered by employer-sponsored retirement plan such as 401(K), your contributions is deductible; Your deduction starts to decline if you (or spouse) participates in a retirement plan through employment and adjusted gross income hits certain level [for 2007, the phase-out limits are $50,000 - $60,000 (single) and $80,000 - $100,000 (joint)];
  • Roth: Contributions can’t be deducted;

Tax advantages

  • Traditional: Earnings grow tax-deferred, but are taxable at withdrawal;
  • Roth: Both principal and earnings are tax-free if you take the distributions after age 59.5 and have established your IRA for five years or more;

Withdrawal

  • Traditional: Must start to withdraw at age 70.5;
  • Roth: No age limit;

Contribution limits

  • Traditional: $4,000 ($5,000 for age 50 or above) in 2007 and $5,000 ($6,000 for age 50 or above) in 2008 and 2009;
  • Roth: $4,000 ($5,000 for age 50 or above) in 2007 and $5,000 ($6,000 for age 50 or above) in 2008 and 2009;

From what we can see, Roth IRA offers much more flexibilities than Traditional IRA on withdrawals and long-term tax advantages (you may not pay taxes at all on earnings), though it has no immediate tax benefit at the time you make the contribution. If you are considering an IRA account, but haven’t opened one yet, you have until April 17, 2007 to set up your account and make 2006 contributions.

For more information on IRAs, check out IRS Publication 590. Fool.com also has a nice (and complete) coverage on this topic.

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5 Responses to “Key Differences between Traditional and Roth IRA”

  1. JAF |  Apr 11, 2007 at 9:55 pm

    There is something I am curious about though. I have a ROTH IRA with Scottrade and most of the money is invested in various mutual funds. But I have about $2000 in this account that I just started playing the stock market with, within this ROTH. Is using funds from a Roth account to play the market a bad idea as opposed to opening up a separate regular trading account?

  2. The Sun |  Apr 12, 2007 at 12:59 pm

    JAF, the answer to your question depends on how often you “play the market.” The good thing about trading stocks in a Roth is that you don’t have to pay taxes for all the capital gains you earned from trading. If you do the trading outside an IRA account, then you are responsible for taxes for the gain. On the other hand, the problem with frequent trading is that you also have to pay commissions for each trading. Doing it too often will eat your profits. IRA account is supposed for long term investment, thus frequent trading and paying fees every time isn’t a long-term cost efficient strategy, in my opinion.