Traditional IRA or Roth?

Readers: This is the second part of a two-part article. The first piece, Retirement on $20 a week, is a guest post featured over at Ms. Money Savvy.


The words IRA make a lot of people freeze up. In fact, they're not nearly as intimidating as you might think. Here, we'll cover the basics of the two main type of IRAS -- traditional and Roth. Then we'll take a look at what these differences mean for people in terms of their goals. That will help you figure out which one will work best for you.


So, since we're reviewing the whole subject, I'd like to start with the most basic item. Most of you probably know it already, but why not cover all our bases?


The basic basics


What does IRA stand for?


C'mon... You know this.


The answer was "Individual Retirement Account." (We would also have accepted "Individual Retirement Arrangement.")


We all know vaguely that IRAs are for retirement. But what are they, exactly?


You might think of a deduction from your paycheck, which is actually only for traditional IRAs. You might know vaguely that some tax benefits are involved. Mostly, though, the majority of us just create the account, throw money into it and hope that the fund managers know what they're doing.


It's actually not that bad. There are a few things you should know about IRAs in general:


• The soonest you can withdraw money free of penalty is age 59 ½
• There is a 10% tax penalty for early withdrawal
• The current limit is $5,000 for individuals under 50
• People 50 and over can deposit up to $6,000



Getting started


The problem with a lot of IRA explanations is that they focus mainly on the end product. That's important, obviously. But most people are scared of the stuff that comes at the beginning.


You might start to sweat when you think about visiting various brokerage firms. Or perhaps you get a headache just thinking about reading a prospectus.


Breathe deeply. It will be okay.


If you go with a traditional IRA, your company will already have a brokerage firm selected. That is certainly one benefit. Otherwise, you are on your own to a certain extent. But always feel free to ask friends and family who they use and how their experiences have been.


Also, remember that you can get your IRA through your bank. That's what my husband and I did. It was relatively simple. There was a lot of paperwork to sign, but it was pretty standard. And we were out the door no more than a half hour after we sat down.


It is true, we should have done more homework, read a prospectus or two. But we needed to get our feet wet, and we had a lot of other stuff on our plate. Sometimes there is value in keeping things simple, just to get started. If you're very panicky about IRAs, this is something to bear in mind.


So, once you're seated in the bank or brokerage firm, now what? Now you'll sign a lot of paperwork. But first you have to decide what level of risk you are comfortable with. You can specify, you see. And in this sort of economy, it is vital that you do. Younger people tend to be more comfortable with higher risk, since they can afford some reversals of fortune along the way. Tim and I, however, have an uncertain future when it comes to earnings. So we will probably stay with low risk, since we might be more affected by losses.


Whatever you choose is okay, and the broker will help you decide. Just be sure you don't get pressured into something you aren't comfortable with. Once you've invested, switching to a higher- or lower-risk fun will involve trading fees.


Okay, now there's just the main question: Traditional IRA or Roth?



Everything you ever wanted to know about IRAs (but were afraid to ask)


You can't know which is right for you without knowing what each has going for it. So I've made a nice, simple, bulleted overview. (You'll probably notice that these are very different. They are made to appeal to different situations, different populations. It actually makes choosing much easier.)




Highlights of a traditional IRA:

• Taken out pre-tax
• Contributions may be tax deductible
• Cannot contribute past age 70 ½
• Taxes are paid at the time of withdrawal
• Must start to withdraw by age 70 ½
• You must withdraw a certain amount, as dictated by the IRS.


Highlights of a Roth IRA:

• Taken out post-tax
• Contributions are never tax deductible
• No taxes paid upon withdrawal
• No mandatory withdrawal age
• Contributions are allowed throughout your life
• Principal can be withdrawn without penalty




Which one is right for you?


Okay, you read the bulleted stuff. And you still have no idea what that means for you. Don't feel bad. I had to have this stuff explained and re-explained to me.


Let's look at the implications of the IRAs' characteristics:


Traditional IRAs


Traditional IRAs have more restrictions than a Roth: an RMD (required minimum disbursement), which you have to start taking by age 70 ½, and past that age, you can no longer make contributions. (It’s worth noting that Congress suspended the mandatory withdrawal rule for 2009, given the depressed stock market.)


The finite window on contributions means that traditional IRAs probably won’t work for people who are getting a late start on saving for retirement.


Similarly, if you plan on working past age 70 ½, a traditional IRA may be a problem. It would mean you are still drawing an income when you start to receive IRA funds. This will probably raise your tax bracket to a much higher level -- which is a problem since traditional IRAs are taxed at the time of withdrawal.


I mentioned RMD before, but it’s important that you understand how it is calculated. The IRS takes the value of your IRA on the last day of the year, divided it by the number of years left, based on life expectancy tables.


Why does this matter? Well, if people in your family tend to live long lives, this IRA may not be for you. Since life expectancy is calculated with averages, you may outlive the agency’s expectation. In that case, your funds will be gone.


So those are the drawbacks to traditional IRAs. But this type of plan can have plenty of benefits for middle- and upper-class workers – especially those without many tax deductions.


Workers who don’t have many deductions to lower their taxable incomes can rely on traditional IRAs to do this. When the contributions are taken out of pay, they are removed before taxes are applied. This means that your contributions to a traditional IRA lower your taxable income. Depending on your income, you may also qualify for a tax deduction, lowering that amount further.


The real value, though, comes in retirement. If the money hadn’t been taken out as contributions, it would have been taxed at your current tax rates. But with traditional IRAs, you don’t receive the funds until you’re retired and, presumably, in a lower tax bracket. So, while you pay taxes on the profits, you're also paying a much lower rate on the original funds than if you had received them in a normal paycheck.


All in all, traditional IRAs will work best for people who:


• Plan on retiring before age 70 ½
• Don’t plan on working after retirement
• Can get a timely start on IRA contributions
• Are currently in higher tax brackets
• Need the tax deductions



Roth IRAs


Roth IRAs, on the other hand, are more lax. You can contribute for as long as you like, and you don’t have to touch a cent until you want to. When you do dip into the funds, there are no rules about how much you have to take. So if you’re not sure how late in life you’ll need to work, a Roth IRA may be best for you.


A Roth IRA is also best for people who plan on having alternate streams of income, such as pensions or real estate investments. They can dip into the funds as necessary, or keep the money earning interest in the IRA.


If your career is uncertain, or you are simply worried that you may need the money later, a Roth is a good fit. With this type of IRA, you can withdraw any and all contributions without any penalties or taxes. (However, if you also withdraw the profits, they will be subject to taxes and to a 10% penalty.)


Finally – and perhaps most importantly – Roth qualified disbursements (taken out under proper conditions) are not taxable income. See, you already paid taxes on this money, before you put it into the Roth IRA. So any profits are completely tax free. This allows you to stay in a low tax bracket, even in retirement, but still have some financial help beyond Social Security.


While there are many benefits to a Roth IRA, it’s important to note one major drawback: There are no immediate tax benefits for contributing to a Roth IRA. Your taxable income won’t be lowered, and you get no tax deductions. So if you are looking to decrease your present tax burden, this is not the IRA for you.


The traditional IRA postpones taxation until the person is retired and, presumably, in a lower tax bracket. If, however, you already pay a low amount of taxes, it makes more sense for you to use a Roth IRA. You pay taxes now, and get tax-free profits later.



All in all, a Roth IRA works best for people who:

• Have lower incomes (unmarried people, single-income families)
• Have plenty of tax deductions already
• Want access to their contributions, if needed
• Want to (or have to) work later in life than 70 ½
• Start saving for retirement later in life
• Prefer to let their profits grow tax free




What did we learn today?


So which category did you fall under? Are you clear which IRA will benefit you most? If you're still not sure, review your last few tax returns (and your goals for the future) and you should have a fairly simple choice on your hands.


Once you've decided which one works best for you, go find a brokerage firm or bank and start an IRA. Now. Even if it’s only $20 a week.