Chapter 2. What is the difference between traditional IRA and ROTH IRA?

Individual Retirement Account (IRA) is the king of retirement saving plans. You can set up an IRA at a financial institution such as your bank, brokerage firm, or IRA providers. IRAs hold investments in stocks, mutual funds, bonds, and cash earmarked for retirement. IRAs come in a variety of forms and with a range of characteristics. You can open a traditional IRA or a ROTH IRA. The Internal Revenue Service (IRS) limits how much an individual can contribute to an IRA each year and decides how the funds are taxed or protected from taxation when an investor makes deposits and withdrawals (depending on the type of IRA).

 

How to

So, what are the differences between the traditional IRA and ROTH IRA?

 

 

Traditional IRAs

• • Traditional IRAs can be funded at a financial institution
  • Yearly limits are based on age, which allows older individuals to contribute more to catch up
  • Annual contributions are pre-taxed, this means that your investment and growth will be tax deferred, and taxable at your specific tax rate at the time of withdrawal
  • You must have earned income in order to qualify to contribute
    • Contributions might also be tax-deductible for federal tax purposes, which lower your tax burden of the year you make the contribution
  • Qualification for tax deduction varies depending on your income and your filing status
    • To make informed decisions, you need to understand any tax implications (positive and negative) fully
      • You can start withdrawing funds at age 59 1/2
  • Traditional IRAs require minimum yearly withdrawals starting at age 70 1/2
    • Withdrawals are subject to federal income tax for deductible contributions, but are tax-free for nondeductible contributions

ROTH IRAs

• • ROTH IRA -- named after its legislative sponsor and Delaware Senator (1971-2001), William V. Roth, Jr. -- became available in 1998 as part of the Tax Relief Act of 1997
    • Allows investors to contribute and save after-tax money (net income after tax)
    • It is funded by a financial institution, and contributions are after tax
      • Contributions are not tax-deductible, but earning grows tax-free
    • As long as you own it for at least five years, you can take tax-free distributions beginning at age 59 1/2, but you are not required to withdraw minimum yearly funds at age 70 1/2 as you are in a traditional IRA
  • ROTH IRAs offer more lenient rules for withdrawals, given that it is your net income invested for retirement.

 

There are pros and cons for each of these retirement funds. It is critical for you to establish one or the other or both if you qualify, especially if your other retirement plans through employment will not sufficiently meet your standard of living at retirement. You need to plan holistically for your retirement to reach sustainability of income for your golden years.

 

Practice

Now you know the difference between a traditional IRA and a ROTH IRA. Think of paying it forward and discuss pros and cons of each plan with a friend or a family member.

 

Congratulations! You can move on to Chapter 3. How to write your own retirement planning guide?

To review the full module on Retirement planning, click here.