The Traditional IRA Vs The Roth IRA

Traditional IRA: A Break On Taxes Up-Front

Under the Taxpayer Relief Act of 1997, individuals who have earned income and are within certain income limits may contribute up to $2,000 a year to a traditional, tax-deductible IRA or to a Roth IRA.

For many, the traditional IRA is more attractive. Here’s why:

1. Help Now From Uncle Sam. If you qualify for a tax deduction for your IRA contribution, Uncle Sam effectively helps to foot the bill. For investors in the 28% tax bracket, for example, a $2,000 IRA contribution nets a $560 tax savings. This deduction means that many investors can afford larger IRA contributions. Although you’ll pay taxes when you ultimately withdraw money from your IRA, in the meantime your money grows and compounds on a tax-deferred basis.
2. Your Tax Rate May Drop. If you expect to be in a lower tax bracket after you retire, the traditional deductible IRA may make a lot of sense. If your deduction for an IRA contribution in 1998 shelters income from a 28% tax rate and if your IRA withdrawals would be taxed at a 15% rate, the deductible IRA probably will net you more than a Roth IRA. (Actual results depend on several variables, including the amount of your IRA contributions, the return on your IRA investments, and future tax rates.)
3. Wider Eligibility. Many more people will be eligible to take a tax deduction for IRA contributions made in 1998. The new tax law raises the income limits that govern whether IRA contributions are deductible for those covered by retirement plans at work. It also ends the practice of treating one spouse as an active participant in a retirement plan merely because the other is covered. This change will enable many individuals to claim deductions for IRA contributions even when their spouses cannot. (Note that nondeductible contributions may be made to a traditional IRA regardless of income, while contributions to a Roth IRA are prohibited for couples with adjusted gross income exceeding $160,000 or single tax filers with adjusted gross income exceeding $110,000.)

Roth IRA: Tax-free Growth, A Bigger Potential Payoff

Although contributions to a Roth IRA, which may be made starting in 1998, do not qualify for a tax deduction, this new retirement-savings option has compensating features that make it the better IRA choice for some investors. Among these features are:

1. Totally Tax-free Growth. Earnings on a Roth IRA can be withdrawn totally free of federal income tax if the account has been held for at least five years and the account owner has reached age 59 1/2. (Tax-free distributions can be taken before age 59 1/2 if the account has been held five years and the withdrawals are due to death or disability, or are for expenses of a first-time home purchase.) Tax-free growth of your IRA is especially attractive if you think tax rates when you withdraw the money will be higher than those you face now.
2. You Can Shelter More. In effect, the Roth IRA allows you to shelter more money in an IRA. The $2,000 annual contribution limit is the same for traditional and Roth IRAs. But because your contribution to a Roth IRA is made with after-tax income while your contribution to a deductible IRA is made with pretax income, a $2,000 contribution to a Roth IRA turns out to be equivalent to more than a $2,000 deductible contribution. In short, the Roth IRA effectively allows you to defer taxes on a larger sum than the deductible IRA. For this reason, the Roth IRA is the better choice if you can afford a full $2,000 contribution, provided that tax rates when withdrawals are taken are not markedly lower than those in effect when the contributions are made.
3. Relaxed Rules. In contrast to a traditional IRA, eligibility for a Roth IRA is not affected by your participation in an employer-sponsored retirement plan. Another difference is that with a Roth IRA, the account owner does not have to take required minimum distributions after age 70 1/2. Also, those with earned income may contribute to a Roth IRA after reaching age 70 1/2, which is not permissible with a traditional IRA.

All information provided is general in nature and intended to create awareness, not to address the specific circumstances or concerns of any individual or entity. Although we try to provide correct and timely information, we cannot guarantee the accuracy of any information or that such information will continue to be accurate in the future due to the changing nature of the tax laws. Before acting on any of the information provided here, you should consult with a professional advisor who knows all of the unique facts and circumstances pertinent to your particular situation.