Selecting the right IRA could improve your retirement
Roth or Traditional IRA: What's the Difference?
by Debra L. Karplus, MS, OTR/L
The Roth IRA
Starting an IRA
In olden days, Grandpa probably received a generous pension that gave him and Grandma peace of mind for a blissful, worry-free, financially comfortable retirement. All Grandpa needed to do was to stay employed, which, unlike today, was almost guaranteed if he performed his job with reasonable performance, and the pot of gold at the end of the rainbow awaited him. But, the financial world is ever changing, and the yellow brick road to retirement looks unrecognizable from days gone by. Don't expect your retirement plan to resemble Grandpa's or even Mom and Dad's. You'll need to become proactive and stay informed about funding your individual retirement in a style that matches your life and personal financial goals.
Individual retirement plans have evolved over the twenty-five years.
Individual Retirement Accounts (IRA) seem like they've been around forever, but they only first surfaced in 1974 when federal legislation was passed to allow $1500 annually to be invested into a specific fund earmarked as a tax-deferred IRA. Between ages 59 1/2 and 70 1/2 years old, a person could withdraw IRA distributions penalty-free. The age limits have remained the same over the years, but the maximum allowable IRA contribution has increased. Federal legislation in 1981 enhanced the IRA. Most people today refer to this retirement tool as a Traditional IRA, not to be confused with other retirement plans that have come into existence since its inception.
The Simplified Employee Pension Plan (SEP) evolved in 1978. This specialized IRA, similar to the Traditional IRA, is designed for self-employed persons. A percentage of net earnings, as designated on Internal Revenue Tax Schedule C, is an allowable deduction, but there's a maximum dollar amount for SEP-IRA contributions each year.
The Roth-IRA is notably different from a Traditional IRA and it's essential to understand the tax consequences of each.
Tax Relief Act of 1997 created the Roth-IRA, named after Senator William J Roth, Jr. Education IRAs came into fruition as part of this legislation, also. The Roth-IRA allows a person to make contributions into a specific fund earmarked as a Roth-IRA that is not tax deductible. At first glance, one might think that's a bad idea. But, the good news is that no federal income tax is paid when withdrawn after age 59 1/2; if this investment has grown in value, which hopefully it has, it's a terrific deal. For example, if during your working years, you put $100,000 into your Roth-IRA, and at age 59 1/2, it's worth $200,000, you pay no income tax on any of it!
There's a maximum yearly allowable contribution to your Roth-IRA. If you're single, with modified AGI (adjusted gross income) less than $107,000, you can contribute $5000 annually to your Roth. For incomes between $107,000 and $122,000, you can contribute a lesser amount. Folks over 50 can contribute $6000.
You're probably too young to see the value of no maximum age for taking Roth-IRA distributions. But ask your Grandparents when they return from their cruise or from playing golf; they may still be very active in their seventies, as people live longer today.
It's essential that you don't underestimate the tax implications of different types of IRAs.
Though the maximum age for making withdrawals and other subtle variances make the Tradition IRA and Roth-IRA different from each other, the main characteristic that sets them apart is the tax implications. The Traditional IRA is tax deferred, which means you pay federal income taxes on the gains when you withdraw money. The Roth-IRA is tax-free.
How do you decide whether the Traditional IRA or Roth-IRA is right for you?
There are many online calculators that can help you decide the right kind of IRA, but if your income is over $122,000, the Internal Revenue Service (IRS) requires you to choose a Traditional IRA instead of a Roth.
Perhaps even more important is to look at your total income and make your choices. The Traditional IRA has some restrictions related to your employer pension that don't exist for the Roth. Since some people have an unusual work situation, you must take a closer look. For example, you may have a part-time job with a University that offers benefits and you are required to be in the State University Retirement System (SURS), and you chose to also be in their 403B program. Additionally, you are self-employed somewhere else as a freelancer and opened a SEP-IRA account at a brokerage firm. Maybe you also do some substitute teaching and are required to be in your state's Teacher Retirement System (TRS). Make sure you know the rules before you open or add money to a Traditional or Roth-IRA.
The IRA may be the best invention since the dollar bill. Be cautious and make sure you understand the tax implications and rules for other retirement plans you might have before getting started. For as little as $500, any bank or brokerage firm can help you get started.
(editor's note: Figures are for 2011. Please seek appropriate accounting and investment advice before making any decisions.)
Debra is an occupational therapist, accountant, teacher and freelance writer. She is a writer for Advance for Occupational Therapy Practitioners. She also writes for Grand Magazine, has some items (fiction and non fiction) selling on Amazon.com (kindle), has written several travel articles for the Champaign-Urbana News-Gazette and several articles for freelancewriting.com. Learn more about her at DebraKarplus.blogspot.com.
Take the Next Step:
- For more on IRAs and saving for retirement, please click here.
Share your thoughts about this article with the editor: Click Here
Debt from my past is preventing me from saving for my future! Tell us: Yes, debt is hindering my ability to save and I could use help dealing with it! or No, debt is not a problem but I am trying to get ahead financially!
More Money Tips & Tools
- 5 low-risk ways to earn higher interest now
- 10 easy ways to save money for the holidays
- 7 IRA withdrawals that don't trigger a penalty
- 4 secrets to maximize your credit card rewards
- How small changes to your finances could make a big difference
- Learning from our financial mistakes
- 5 ways to make finances easier
- This week's Readers' Tips