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Funding Roth vs. Traditional IRA

Original post by John Kibilko of Demand Media

Traditional and Roth IRAs have similar funding mechanisms and contribution limits, but differences exist regarding eligibility rules, tax implications, and withdrawal and distribution guidelines. IRA legislation was enacted in 1974 with passage of the Employee Retirement Income Security Act to allow people not covered by employer-sponsored retirement plans to save for retirement. Roth IRAs were introduced in 1997 and provide a different tax structure, and consequently more flexibility, than traditional IRAs.

Contents

Characteristics of Traditional IRAs

You must be under the age of 70 1/2 to contribute to a traditional IRA. You also must receive compensation in the form of wages, salaries, bonuses or commissions. Contributions generally are tax deductible, or tax deferred, meaning that contributions are taken from your paycheck before taxes are deducted. There are no income restrictions on contributions, but there are income limits to be able to use it as a tax deduction (depending on whether you were covered by a 401(k)). Taxes are paid on earnings when withdrawals and distributions are made. Funds are used to purchase various investment instruments like stocks, bonds and mutual funds. Mandatory distributions begin at age 59 1/2.

Characteristics of Roth IRAs

Contributions to a Roth IRA aren't tax deductible, they are tax-exempt, meaning that contributions are made in a post-tax fashion but principal-contribution withdrawals and distributions are tax free. There is no mandatory distribution age but there are income limits. Funds are used to purchase the same types of investments available in traditional IRA accounts.

Contribution Comparisons

The contribution limits for both traditional and Roth IRAs are the same, although Roth IRAs have income qualifications attached to the figures. The maximum annual contribution limits for both types of IRAs as of the time of publication is the lesser of $5,000 or the total of your taxable compensation. This amount can be split between traditional and Roth IRAs but cannot exceed $5,000. If you're 50 or older, an additional $1,000 per year can be contributed.

Withdrawal & Disbursement Comparisons

You can withdraw funds -- called qualified distributions -- from traditional IRAs at the age of 59 ½. Distributions made before age 59 ½ result in a 10 percent tax penalty unless you qualify for an exemption, for example if you are disabled or purchasing a home within certain parameters. Normal distributions are taxed as ordinary income. With a Roth IRA, qualified distributions are considered any withdrawals made five years or more after the account was opened as long as you've reached age 59 ½. There are no mandatory distributions. You also can withdraw, without penalty, principal-only contributions you've made. A 10 percent penalty is imposed on some early withdrawals, although Roth IRAs have more early-withdrawal penalty exceptions than do traditional IRAs. Normal Roth IRA distributions are not taxed.

Income-Limit Comparisons

There is no income limit for contributing to Traditional IRAs. The only income requirement is that you must have some form of compensation comprised of wages, salaries, bonuses or commissions. Deferred compensation and payments like interest income and stock dividends don't qualify as compensation. There are income limits on tax-deductibility of Traditional IRAs, however, if you and/or your spouse are covered by a 401(k) plan.

In order to be eligible for Roth IRA contributions as of the time of publication, your modified adjusted gross income must be less than $177,000 a year if married and filing jointly; less than $120,000 if you're a single or head-of-household filer, or married and filing separately and you didn't live with your spouse during the year; or less than $10,000 if married and filing separately and you lived with your spouse at any time during the tax year.

Conclusions

Traditional IRAs allow for tax-deductible and tax-free contributions, decreasing participants' yearly taxable income. This can allow you to lower your tax bracket during your working years and withdraw retirement funds when you're in an even lower tax bracket. But income requirements for deduction remove this benefit for most workers. Also, mandatory age rules require investors to take distributions regardless of whether they want to.

Tax-free withdrawals are a big advantage of Roth IRAs, as is the fact that there isn't a mandatory distribution age. However, Roth IRAs have income requirements that disqualify some people.


                   

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About the Author

John Kibilko has been writing professionally since 1979. He landed his first professional job with "The Dearborn Press" while still in college. He has since worked as a journalist for several Wayne County newspapers and in corporate communications. He has covered politics, health care, automotive news and police and sports beats. Kibilko earned a Bachelor of Arts in journalism from Wayne State University.



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