Updated: August 1, 2012
Individual retirement accounts (IRAs) are one of the most well-known ways to save for retirement. Essentially, an IRA is an account that carries a special status with the IRS and enables investors to defer hundreds of thousands of dollars in taxes.
There are several kinds of IRAs, and each has its own requirements, restrictions, limits and tax treatments, but the Traditional and Roth are two of the most common. Choosing which one is right for you can significantly affect today's tax bill, as well as how much you have to bank on 20 or 30 years down the road.
How Do IRAs Work?
Opening an IRA is fairly straightforward. First, an individual must establish an account with a bank, brokerage firm or mutual fund company. These firms then act as a fiduciary, though the individual is responsible for establishing the IRA and selecting the plan investments.
IRA account owners can invest in stocks, bonds, CDs and mutual funds, but some trustees also allow nonstandard assets to be held in IRAs. Some of these nonstandard assets include real estate, REITs, futures, options and U.S.-minted gold and silver coins.
Once the account has been established, the individual can contribute a maximum of several thousand dollars per year (the contribution limits often change annually; for instance, the limit for Traditional IRAs was $5,000 per person in 2010, or $6,000 for those 50 and over). Participants age 50 and over are often eligible to make additional 'catch-up' contributions to their IRAs beginning in the year they turn 50, and investors are no longer allowed to make contributions to Traditional IRAs after the age of 70 1/2.
Annual Contribution Limit for IRAs
Year Limit 50+Limit
2010 $5,000 $6,000
2011 $5,000 $6,000
2012 $5,000 $6,000
Differences Between Traditional And Roth IRAs
The big differences between Traditional and Roth IRAs center on two things: the tax treatment of contributions and the tax treatment of withdrawals.
IRA contributions are typically deductible if the IRA is a Traditional IRA, but they're not deductible if the IRA is a Roth. It's important to note that people who work for companies with employer-sponsored retirement plans are usually not allowed to deduct Traditional IRA contributions unless their incomes fall below certain income limits.
Another big difference between Traditional and Roth IRAs revolves around when investors may begin withdrawing money from their accounts -- also known as taking distributions. Although, technically, the investors can take their money out of an IRA at any time, investors who make withdrawals from a Traditional IRA before age 59 1/2 almost always have to pay huge penalties. (There are certain exemptions that help people avoid paying those penalties; examples include disability, financial hardship and death, but there are other exemptions.)
Keep in mind that you don't have to take distributions from a Traditional IRA if you're over 59 1/2 -- that only happens when you reach age 70 1/2.
Withdrawals from Roth IRAs, on the other hand, can happen any time and are completely tax-free in most circumstances. This sounds great, but remember that contributions to Roth IRAs are not tax deductible. (Traditional IRA contributions typically are.) They are made with after-tax money. Withdrawals made at or after age 59 1/2 from a Traditional IRA are taxed, typically at ordinary income levels.
It's important to highlight that last point: Withdrawals from Traditional IRAs are taxed at ordinary income levels. The investor benefits from the fact that, as long as the money is in the account, he or she is not paying taxes on the capital gains on the account. The investor also benefits from the fact that when she eventually does make withdrawals, she will probably be in a tax bracket that is much lower than was probably the case when the investor was in her peak earning years.
This leads to one of the biggest factors in choosing between Traditional and Roth IRAs: Because the IRS taxes you either coming or going, consider whether your current tax bracket is higher or lower than the bracket you expect to be in when you retire.
For example, if you're in the 35% tax bracket, a tax deduction for contributing to a Traditional IRA is worth a whole lot more to you than to someone in the 15% tax bracket -- especially if you think you'll be in a much lower tax bracket when you start paying taxes on the withdrawals (because you won't be working). But if you're in a lower tax bracket now, putting post-tax money into a Roth and then taking tax-free withdrawals could be far more advantageous.
Another factor that will help you decide pretty quickly between Traditional and Roth IRAs is your income. Roth IRAs are available only for filers who make below a certain amount.
Here's how that looked in 2012:
Single filers: You can contribute up to the limit if your adjusted gross income was less than $110,000. If it's higher than that but lower than $125,000, you can contribute a reduced amount. If your income is more than $125,000, you can't contribute at all.
Married filing jointly: You can contribute up to the limit if your adjusted gross income was less than $173,000. If it's higher than that but lower than $183,000, you can contribute a reduced amount. If your income is more than $183,000, you can't contribute at all.
The Investing Answer: Many investors may think that asset allocation is the only important factor when it comes to selecting retirement investments, but as you can see, the tax consequences of the vehicles into which you put your assets also has a huge impact on the amount of money you have for retirement. Finding an IRA that best fits your circumstances is one way to make your money work harder for you.