Comparing Traditional and Roth IRAs

Individual retirement accounts, or IRAs, can be just the ticket. Like 401(k) and 403(b) plans, IRAs offer tax benefits. This course covers the two most popular types of IRAs: the traditional IRA and the Roth IRA.

How to Invest in an IRA
The IRS allows anyone to invest money each year in a traditional IRA, although there are contribution limits: $5,000 in 2008 and 2009 (or $6,000 if you're age 50-plus). Depending on your adjusted gross income, you may not be able to invest that much--if anything--in a Roth IRA. See the IRS' Web site at www.irs.gov for details.

IRAs can be invested in any type of publicly traded security, including stocks, bonds, and mutual funds. Generally, there's no limit to switching investments or money managers within an institution, although there could be tax penalties involved if you switch between different types of IRA accounts. Some institutions tack on fees for switching accounts to another firm.

The Difference Between Traditional and Roth IRAs
Many investors qualify for a tax break, either up front or when they withdraw the money from the account. For those who qualify (consult the IRS' site to determine if that's you), a traditional IRA provides an up-front tax savings.

For example, if you are married and filing jointly and neither you nor your spouse was covered by an employer-sponsored retirement plan, all of your contribution to a traditional IRA plan could be tax deductible. (To learn about your individual situation, however, consult the IRS Web site at www.irs.gov).

You will pay taxes on your investment gains when you withdraw from a traditional IRA account. Currently, money withdrawn from your traditional IRA account is taxed as ordinary income at retirement.

The Roth IRA doesn't provide any up-front tax advantages the way a traditional IRA does. Contributions are not tax deductible. But once you begin withdrawing from a Roth IRA in retirement, all your earnings are tax-free. The only catch: You have to have invested money in this account for at least five years before you take any money out.

If you convert a traditional IRA to a Roth IRA, you'll pay taxes on deductible contributions and earnings made up to the point of conversion. But as soon as the money is placed in a Roth, it grows tax-free. (Note: The Tax Increase Prevention and Reconciliation Act of 2005 allows anyone, regardless of income level, to convert a traditional IRA to a Roth IRA in 2010 and beyond. Currently, those with adjusted gross income above $100,000 are not eligible for conversion.)

The Roth Advantage
The Roth IRA has several advantages over the traditional IRA:

Roth Raises the Income Ceiling. Many investors, particularly those who already participate in a retirement plan at work, will find that the Roth IRA is their only option: The modified adjusted gross income (AGI) cut-offs for traditional IRAs are relatively low. The legislators were more generous with the Roth IRA, though.

Granted, an investment in a Roth IRA doesn't cut tax bills today; remember, Roth IRA contributions are made with aftertax earnings. But money invested is free to multiply, unfettered by capital gains or income-tax bites along the way.

Most Ways You Slice It, a Roth Grows More. Even if you don't qualify for deductible IRA contributions, you could make nondeductible contributions to a traditional IRA and enjoy tax-deferred growth on your savings.

But go for a Roth if you qualify. Roth earnings are not simply tax deferred--they're tax free, forever. Provided you've held the Roth for at least five years and are at least 59 1/2 years old when you begin withdrawing from the account, you don't owe taxes on distributions. (See IRS Publication 590 for a few picky exceptions.)

Some people eligible for a deductible IRA won't want to give up the "bird in hand," that is, a tax deduction today. Keep the big picture in focus, though, and you'll notice the long-term advantages of the Roth. Those tax-free distributions in retirement are quite a boon.

Several factors determine whether the Roth is the best choice for you: age, investment return, current tax bracket, and retirement tax bracket. Enter your personal variables into an online calculator, such as Morningstar.com's IRA Calculator, and pick which IRA best suits your situation.

In general, the more time you have and the higher your expected return, the better the Roth looks. And the higher your retirement income is likely to be, the greater the advantages of a Roth. Considering that marginal tax rates are closer to historic lows than historic highs, it is quite possible that your retirement tax rate won't be any lower than it is today--it could even be higher.

So when do traditional deductible IRA contributions seem the better bet? Most often, for people in a high tax rate today--but such investors are less likely to be eligible in the first place.

Flexible Rules Mean Easier Access to Your Money. You can typically start withdrawing from traditional IRAs after you turn 59 1/2, but you must begin taking annual distributions after you turn 70 1/2.

If you take an early withdrawal from your traditional IRA, you will pay a 10% federal tax penalty plus the income tax on the taxable portion of the distribution. In the case of death, disability, or divorce, or for those individuals who need to tap the IRA to pay for certain medical expenses, it's possible to sidestep the early-withdrawal penalty. In addition, you may also avoid the 10% penalty by taking "substantially equal periodic payments," monthly or annually, without interruption, based on your life expectancy.

The money you invest in a Roth IRA, meanwhile, can be withdrawn at any time, since you paid income taxes on the money before investing it. And as long as your Roth account is at least five years old, there are four situations in which you can draw money from your earnings tax-free: reaching age 59 1/2, disability, the purchase of a first home (in which case up to $10,000 may be withdrawn), and, of course, death.

Another perk of the Roth IRA--you aren't required to take withdrawals at age 70 1/2, as you are with a traditional IRA. That means your money can grow tax-free as long as you like and be transferred in full to your heirs. (Depending on the size of your estate, however, heirs may have to pay estate taxes.)

With a traditional IRA, in contrast, your beneficiaries will pay ordinary income taxes on the account balance based on their tax brackets. An heir can avoid paying a large amount of tax up front and take advantage of compounding by taking distributions over his or her life span. Unfortunately, many people take the lump-sum payment because they're not aware of this option. The tax-deferred status of the traditional IRA can only be transferred to a spouse. If it's part of an estate and paid to children, they must pay estate and income taxes.

This article is from Morningstar.com's Investing Classroom. Click here for more course offerings.