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What's the difference between a traditional and Roth IRA?

By Kay Bell

In addition to an employer-sponsored retirement plan, one of the best ways to save for retirement is with an individual retirement arrangement (IRA).

With an IRA, you can save part of your income in a tax-favored account, which can help you enjoy life once you leave the 9-to-5 grind.

There are two primary types of IRAs: the traditional version, which has been around since 1974, and the Roth version, which was created in 1997.

Traditional IRAs allow taxpayers (if they qualify) to deduct contributions from their taxable income and earnings in the accounts grow tax-free, only triggering a tax liability when distributions are taken from the account.

Roth IRA contributions aren’t tax-deductible.

Each IRA offers different advantages depending on your personal and tax circumstances. Situations change throughout a lifetime, so it might be better for you to have a traditional IRA at some points, and at other times a Roth.

Don't worry. You can have both types of IRAs in addition to an employer-sponsored retirement plan.

But you should periodically evaluate your personal situation and determine whether your IRA strategy is appropriate.

 

How traditional and Roth IRAs are alike

Traditional and Roth IRAs share some key attributes.

For example, your contributions must be made with taxable compensation, which can include salary, wages, commissions, self-employment income, bonuses and tips, and even alimony or maintenance payments.

You are limited in how much you can contribute each year. For 2016 and 2017, you can only contribute up to $5,500 total each year. If you're age 50 or older, you can contribute an additional $1,000.

Your maximum contribution also can't be more than your taxable compensation for the year. If you earned $5,000, that's the most you can contribute.

If you have more than one IRA, the contributions limit — either based on your earnings or the limit set each year by the Internal Revenue Service — is the total you can put into all your accounts.

This means you can't put $5,500 into a traditional IRA and another $5,500 into a Roth IRA — you'd have to either choose one to max out or split your funds between the two.

You can contribute to either type of IRA as late as the April filing deadline the next year. For the 2016 calendar year, that’s April 18, 2017.

If you’re under 59 ½ and withdraw money from your traditional IRA, you’ll be hit with a 10 percent penalty on the amount you take out.

You can withdraw your contributions from a Roth IRA penalty-free at any time but you may have to pay taxes and penalties on your Roth IRA earnings.

 

How traditional and Roth IRAs differ

There are some key differences between a traditional and a Roth IRA.

Traditional IRA contributions are, in certain situations, tax deductible. Roth IRA contributions, on the other hand, aren’t deductible.

No tax is collected on traditional IRA earnings and gains as they grow. But when you take money out of the account in retirement, you'll owe taxes on that money at your regular income tax rate.

Also, with a Roth IRA, only qualified distributions will be tax- and penalty-free. If you withdraw money from your Roth IRA when you’re 59 ½ or older, you generally won't owe any tax on the distribution as long as you've had the account for at least five years.

And once you turn 70 ½, you must start taking at least some of the money out of your traditional IRA each year as a required minimum distribution. You can leave money in your Roth IRA for as long as you like.

Here's a side-by-side comparison of traditional and Roth IRAs.

The main differences between a Traditional IRA and Roth IRA

 

Traditional IRA

Roth IRA

Who can contribute?

Anyone who has taxable compensation (generally work income) and who is younger than 70 ½.

Anyone who has taxable compensation (generally work income) and whose income is below certain amounts (see 2016 and 2017).

How much can I contribute?

$5,500 (for tax years 2016 and 2017) or $6,500 if you're age 50 or older by the end of the year. Or your taxable work compensation if less than the amounts above.

$5,500 (for tax years 2016 and 2017) or $6,500 if you're age 50 or older by the end of the year. However, if your modified adjusted gross income exceeds certain limits, you may not be able to contribute as much, or at all.

What is the deadline to make contributions?

Your tax-return filing deadline (not including extensions)— generally April 15 of the following year.

Are my contributions tax deductible?

Yes, but the deduction amount may be limited if you (or your spouse) are covered by a retirement plan at work and your income exceeds a certain amount.

No, your contributions aren't deductible.

Are my withdrawals and distributions taxable?

Any deductible contributions and earnings you withdraw are taxable. If you withdraw money before you turn 59 ½, you could also face an additional 10 percent tax unless you qualify for an early distribution exception.

A qualified distribution at age 59 ½ or older, once you have owned the account for five or more years, is not taxable. If you are younger than 59 ½, you may have to pay an additional 10 percent tax for early withdrawal of Roth earnings unless you qualify for an exception. You may withdraw your regular contributions from your Roth IRA(s) at any time without having to include them in your gross income since they were made with already-taxed money.

When must I take account distributions?

Once you are age 70 ½, you must take a required minimum distribution (RMD) by Dec. 31 of each year. For the year in which you turn 70 ½, you may delay your first RMD until April 1 of the following year.

Required minimum distributions aren’t required by the original account owner.

 

Which account should I choose?

Eva Rosenberg, a California-based enrolled agent, tax book author, educator and the internet's TaxMama, recommends making an IRA choice based on your stage of life.

As your career progresses, it could be a good time to fund a traditional IRA as well as your workplace 401(k), Rosenberg says. "If you can split them 50-50, that's the best of both worlds. You may be able to get a deduction for some of the contributions and grow the rest."

Once you retire, Rosenberg says it might be worth returning to a Roth IRA.

"In retirement, you're likely facing a fixed income and possibly high insurance and medical expenses. This is a good time to move those taxable IRA and 401(k) funds to nontaxable Roth IRAs," Rosenberg says.

You can convert any traditional IRA account to a Roth. With a Roth conversion, you'll typically pay taxes on any untaxed amounts in the traditional IRA, but you may be able to withdraw your money tax-free after retirement.

To maximize the conversion, make sure you have money to pay the taxes upfront so you don't have to use the retirement funds to pay the tax bill.

 

About the Author: Kay Bell has been a dedicated tax geek for two decades. The award-winning journalist, book author and creator of the Don't Mess With Taxes blog is a native Texan (that explains her blog's name). She's also an avid sports fan, so when she's not delving into the Internal Revenue Code, she's sorting through the performance stats of her Baltimore Orioles, Houston Astros, Washington Capitals and Dallas Cowboys. Connect with her on Twitter @taxtweet.

Disclaimer: We know taxes are complicated, so we provide this information for general educational purposes only. It isn’t intended to be personalized legal, financial or tax advice, and we don’t guarantee the accuracy, completeness or reliability of this content. If you have questions about your personal tax situation, consider contacting an accountant, tax attorney or financial advisor. Come back to Credit Karma Tax when you’re ready to file your taxes for free!

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