Roth Vs Traditional IRA

Saving for retirement is (or at least should be) a priority for most people.  That said, there are so many competing options for your investment dollars, it’s sometimes difficult to know what to do.  Understanding your options will help you make good decisions about how to allocate your resources amongst various types of accounts so it can benefit you the most over the long run.  Here is a comparison of similarities and differences of Roth vs Traditional IRA savings accounts, which are two of the most popular options:

Traditional IRA

A traditional IRA is considered a “tax deferred” savings option.  In this type of account, you can put pre-tax earnings into an IRA up to the maximum contribution limits determined by the Internal Revenue Service ($5,000 in 2010, indexed to inflation thereafter).  Provided you keep your hands out of your traditional IRA until you are at least 59 and a half years old, the contributions and earnings in your account will grow tax-deferred.

When you withdraw money from a traditional IRA at regular retirement age, the money is taxed as regular income.  If you withdraw money from a Traditional IRA before age 59 and a half, you will also have to pay a 10% penalty to the IRS, unless you meet certain hardship withdrawal criteria.

Roth IRA

The Roth IRA is another savings option for putting money aside for retirement.  Instead of contributing before-tax money, contributions into a Roth IRA are taxed before you make the deposit.  When you withdraw money from the Roth IRA at the age of 59 and a half (or older), both your principal and earnings are completely tax-free.

In order to discourage early withdrawals, Roth IRAs are subject to the same 10% early withdrawal penalty as Traditional IRAs.

Roth Vs Traditional IRA

When deciding between a Roth vs Traditional IRA, you should first determine whether you think your taxes will be higher or lower in retirement.  If you believe your tax rate will go down in retirement, you’re probably better off contributing to a Traditional IRA.  If you think taxes will go up, you’re probably better off with a Roth.  In light of current budget deficits, chances are future tax rates will be higher than current rates.

It’s important to keep in mind that your decision is not final.  You can convert an existing Traditional IRA into a Roth IRA (even high-income taxpayers are eligible in 2010), but will have to pay taxes on the amount converted.  I advocate converting only if you have enough cash to pay the taxes owed without having to dip into principal.

One final rule of thumb:  when in doubt, you’re usually better off choosing a Roth IRA over a Traditional IRA.  Popular places to open an IRA are Vanguard (where I hold my accounts), T Rowe Price (for beginning investors with little to invest at first), Tradeking (for investors who prefer buying ETFs over mutual funds), and Zecco (another discount brokerage with inexpensive trades)